All too often, inexperienced investors blindly jump into whatever investment has performed best recently. But as much as Treasury bonds defied the odds to post strong returns in 2011, they look even worse as a long-term investment now -- and you need to understand the risks involved before you put another penny into bonds.
Later in this article, I'll give you some alternatives to bonds that I think are poised to perform better in 2012 than Treasuries. But first, let's take a look back to understand why bonds have done so well -- and why they could hurt investors who buy them right now.
The long bull market
During the depths of the financial crisis in early 2009, investment researcher Rob Arnott took a look at the past returns on stocks and bonds and made a disturbing finding: Over the 40-year period that began in 1969, Treasury bonds actually outperformed stocks. That belied the notion that stocks automatically earned investors a "risk premium" over ultra-safe Treasuries.
Since 2009, stocks have rebounded sharply. But even now, bonds have still beaten the returns on stocks over the past 30 years. That's why many investors are jumping into investments like iShares Barclays 20+ Year Treasury -- a bond ETF that jumped more than 33% in 2011.
Stop looking backward
The problem with that philosophy, though, is that it's entirely backward-looking. In the late 1970s and early 1980s, inflation was running rampant, as interest rates reached record levels. In late 1981, you could have earned a yield of more than 14% on a 30-year Treasury bond.
Nowadays, those rates sound absurd. The rate on 30-year bonds today is less than 3% -- and that's down from 4.36% at the end of 2010. That big drop in rates is the reason for the strong return on bond ETFs -- but it also proves how unlikely further gains are.
Buying a 30-year bond today means accepting a long-term annual return less than inflation has been over the past 12 months. Essentially, you're accepting defeat, believing that there's no way you can even keep up with rising prices over the next three decades. And if rates go up, the value of your Treasury bond will fall sharply.
The better bet
The last 30 years are history. What you want now are investments that will give you good returns for the next 30 years. With bond yields at ridiculously low levels, stocks look like a much better bet -- and in particular, stocks that pay you better yields than Treasuries while having very reasonable valuations and a history of healthy share-price growth have much more potential than bonds.
For example, Chevron (NYS: CVX) yields 3% and gives you the security of Big Oil exposure. Yet even though the stock has returned 12% annually since the end of 1981, it's trading today at less than eight times earnings -- a steal if you think oil prices aren't likely to collapse. Similarly, Eli Lilly (NYS: LLY) , with an earnings multiple of less than 10, carries an even healthier yield of 4.7%. Concerns about its patent cliff abound, but again, Lilly's a big company with a history of developing new products to replace older ones. Another promising area is defense, where Lockheed Martin (NYS: LMT) and several of its peers trade at depressed prices on expected cuts in the defense budget. If those cuts are less severe than most think, then Lockheed has considerable upside potential.
If you have an appetite for higher-risk plays, you can get even bigger bargains outside the U.S. right now. Fears about Europe have beaten down shares of both Spanish bankBanco Santander (NYS: STD) and French giantFrance Telecom (NYS: FTE) , with both sporting yields above 8%. Admittedly, a collapse in the European economy could have a huge impact on these companies for several years. But unless the absolute worst happens, both France Telecom and Santander should survive by extending their reach internationally.
Get out of bonds
There's no reason whatsoever to tie up your money for 30 years at less than 3%. If you need cash, keep it in a savings account, where it will be safe even when rates rise. And as for your long-term investing money, take a hard look at stocks that can give you more income and better future return potential. Only the best investments will help you retire on your timeframe.
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At the time thisarticle was published Fool contributor Dan Caplinger was early on his bond-bear call but is sticking with it. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Lockheed Martin. Motley Fool newsletter services have recommended buying shares of France Telecom and Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is a winner every year.
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