Bonds: Then and Now
Interest rates have risen to start the year. After the yield on the 10-year Treasury reached a nadir of 0.5% basis points during the depths of the pandemic, it recently touched 1.5% - a level not seen since February of 2020. Of course, when bond yields rise, bond prices fall leading to poor bond performance, but rising bonds yields don’t have to spell disaster for bond portfolios.
Bonds, like all assets, are looking forward. The recent higher move in interest rates reflects the market’s stronger outlook for inflation and growth. Bond investors are always concerned about inflation. Owning a bond requires parting with your money in exchange for a fixed return plus the return of principal at maturity. For high-quality bonds, you can be reasonably sure you will get your money back at maturity, which is why bonds tend to be much less volatile than stocks. The biggest risk to bond investors is how much will those dollars be worth when you get repaid. Will they purchase fewer goods than they did at the beginning?
Over time, history has shown that bonds offer compensation for this inflation risk and earn a higher inflation-adjusted return than cash (discussed here). Similar to cash, so much of the return on bonds is compensation for accepting inflation risk. Since 1926, intermediate-term bonds returned a 2.25% annual average over the rate of inflation while cash only earned an inflation-adjusted 0.43% over the same period.
However, that doesn’t tell the whole story. Inflation-adjusted returns for bonds varied by decade. Similar to cash, bonds performed well in the Great Depression era, as falling prices were good for fixed coupon instruments. Mid-century, between 1941 – 1980, several bouts of inflation and a Fed policy of keeping rates lower during wartimes led to lackluster real returns on bonds.
Bonds came roaring back in the 80s as Fed Chair Paul Volker tamped down inflation, kicking off a 40-year decline in inflation and interest rates. In nominal terms, the period after the 1980s was the best period for bonds as intermediate government bonds returned a 7.1% annual average. After inflation, the performance was a more modest but healthy 4.3%.
You needed to accept some fluctuations in your bond portfolio to earn that extra inflation-adjusted return over cash. But even so, this interest rate risk is nothing like the risk in stocks[1]. A bad year in bonds is like a bad week in the stock market.
At the risk of stating the obvious, when interest rates rise, prospective bond returns also rise. Rising rates may temporarily depress prices, but money is also reinvested at higher interest rates, helping recoup losses faster.
Can the inflation of the 80s be repeated? Clearly, 14% inflation would pose a problem for bonds yielding 1.5%. But inflation is a slow-moving phenomenon. It took a series of events to lead up to the inflation shock of the 1980s. First, increased government spending related to the Vietnam War and Lyndon Johnson’s Great Society policies strained production. Then, the oil embargo of the early 70s rocketed gas prices. All this finally fueled higher inflation expectations, which ultimately became somewhat self-fulfilling.
What does this all mean for the future? It’s just as difficult to forecast the bond market as it is the stock market. Even the so-called pros get it consistently wrong from year to year. Still, it’s hard to see bonds put in another 30-year bull run from today’s yields. But it doesn’t necessarily mean that returns will lead to severe long-term losses. The 30-year inflation-adjusted yield derived from TIPS just returned to a positive 0.14%, suggesting inflation-adjusted returns could be somewhere between the mid-century doldrums and the roaring bond market of the last 30 years.
That’s hardly a ringing endorsement for bonds. Treasury bonds and high-quality debt can still act as a stabilizer in a growth-oriented portfolio. Treasury bond’s best returns will likely be during periods of stock market stress, which is bound to happen from time to time. Even in an era of low yields, proper bond management can still play an important risk management role in a balanced portfolio.
[1] This assumes we are talking about intermediate-term government bonds. Long-term bonds, of perhaps 10-year or more to maturity, have exhibited deeper drawdowns. Bonds with credit risk can always default, leaving investors with deep losses as well.
Contact us at 865-584-1850 or info@proffittgoodson.com
Please see disclosures
