What’s Next for Interest Rates?
This year, the yield on a 10-Year Treasury bond reached a new all-time record low of 0.50%. In 1980, the same bond yielded 15%. The secular decline in interest rates provided a tailwind to bond performance over the last 40 years. For most baby boomers and following generations, yields have declined for most of their working life. Now that bond yields have approached zero, have we finally reached the end of this ride? That may be the wrong question.
Today’s low bond yields create a challenge for savers and investors. Many financial planners have offered solutions about what to do in a low-interest rate world. Most suggestions fall into two categories: 1) hold cash instead or 2) take more risk. While today’s bond returns are likely to be lower than historical returns, bonds still have value in a portfolio.
If you buy a 10-year Treasury bond today and hold it to maturity, the return you will earn will be close to its yield at purchase, or about 0.77%. That’s actually a negative return after subtracting the current inflation of 1.3%.
STILL BETTER THAN CASH
Because bond yields are so low, it may be tempting to think cash is a better alternative. After all, cash will hold its nominal value. But despite the low yields on bonds, returns on cash, CDs and similar instruments are even lower. CDs and money market funds offer 0.30% yields, rendering a 1% loss in purchasing power after inflation. Cash is not really as safe as it may seem.
While cash serves a role as the reliable source of liquidity, bonds are better at diversifying stock returns. When stocks perform their worst, investors expect central banks to slash interest rates and demand safe assets. This often results in investors clamoring for the highest quality bonds. The diversification benefits of bonds are most evident during downturns in stocks. This helps reduce drawdowns in a balanced portfolio, easing the pain and panic of a stock market crash.
Even at today's low yields, capital appreciation is still possible. A 10-year treasury bought at a 0.7% and sold at a 0.3% yield three months later would result in a 4% return. That’s a real benefit in a falling stock market. Recent experience in Japan and Germany suggests that bond yields can fall below zero, enhancing their ability to provide diversification during stock market turbulence.
Of course, every turbulent market is different than the previous ones. We believe that high-quality bonds will continue to be attractive when the world feels shaky, providing an effective ballast to more volatile stocks.
OUR BOND STRATEGY IN TODAY’S RATE ENVIRONMENT
The primary risk for bonds is that higher inflation erodes the purchasing power of future bond interest and principal payments. With demand weak, the job market currently soft, and oil prices down, inflation worries are low. But that could suddenly change, especially in this uncertain economic environment. Treasury Inflation-Protected Securities (TIPS) are an important part of a core bond strategy to hedge bond portfolios against future inflation.
In uncertain times, we maintain a diversified approach to corporate bonds, emphasizing high-quality sectors of the market. We are cautious on lower quality debt, as weaker industries and companies are likely to struggle during and post-pandemic. We maintain an allocation to government agency-backed mortgage bonds as a complement to corporate bond exposure.
Municipal bonds, even with liquidity and credit challenges, warrant careful consideration. We favor higher quality states and municipalities with proven tax bases. With sales and income tax receipts falling, investors are looking for a wave of downgrades from the rating agencies. Staying in high-quality municipal bonds limits exposure to the price impact of downgrades.
WHAT IT ALL MEANS
Today’s low interest rates pose a challenge for savers. Low bond yields are one of the great challenges for financial planning. Low yields mean returns on bonds are likely to be lower than the returns of the last 30 years. It also suggests that returns on stocks may be lower as well, as stock prices also key off of interest rates. Those accumulating assets in anticipation of eventual retirement will need to pull on other levers in the financial planning machine. For some, this may force difficult decisions about tradeoffs between current lifestyle and future financial security. For those who have “enough,” low interest rates are less of a concern. Managing your portfolio requires reasonable expectations about future returns and a broad and diverse strategy that prepares you for whatever the future may bring.
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