Interest rates have declined significantly. The 10-year Treasury yield averaged 4.45% over the last ten years, started this year at 3.84%, and stood at 2.52% as of 9/30. What does that mean for portfolios going forward? We note three implications:
- Income from your bonds is likely to decline going forward as bond holdings are eventually redeemed and replaced by bonds with presumably lower coupons.
- The return from bonds from this point forward is likely to be less than that which we have experienced lately, and the risk associated with holding bonds is likely to be greater.
- The relative attractiveness of bonds versus stocks has deteriorated.
To the first point, in an environment of declining interest rates, some may seek to maintain portfolio income by “reaching for yield” (buying longer dated and lower quality bonds). However, we believe this is exactly the wrong time to embrace more risk in bond portfolios.
To the last, consider portfolios of the following six corporate bonds and their counterpart stocks:
These companies’ stocks offer a 0.9% per year yield advantage over their bonds. Moreover, consider that each of these companies has raised its dividend every year for the last 27 years, on average. Today, aggregate stock dividend yields may not actually be very compelling relative to historical averages, but bond yields are less so (and money market yields are worse). Within the set of traditional assets, low bond yields make stocks appear more compelling relative to bond and money market funds, considering only return prospects.
On the other hand, some may consider the points made above and the concerns they may have read of concerning a “bond bubble” forming and question holding any bonds at all. Bonds can and will produce negative returns over longer periods of time than we would prefer. Historically, about one in every 10 years has produced a negative total return for the intermediate bond index (which is heavily dominated by government bonds), and two years in a row of negative bond index returns have occurred twice since 1925 (the historical record is worse for longer dated bonds and for high credit risk bonds). We note that when interest rates rose from 5.2% to 7.8% in 1994, producing the worst single year for intermediate government bonds in the eighty five years, the return was only negative 5.1%, though such an increase in rates would produce a much larger negative one year return from current low yield levels. That would be no fun but a far cry from the sort of devastatingly negative returns associated with bubbles in stocks and real estate.
Bond yields have fallen to an alarming degree. That is great for the recent historical returns of bonds looking backward from here. But looking forward, that means portfolio income generation is likely to decline for a time, and it also means that bond returns prospectively are likely to be lower on average with more frequent periods of negative total returns in any given year. Bonds, however, continue to play an essential risk management role in balanced portfolios, so we are certainly not making a case for abandoning the asset class. We just want to be sure that expectations are appropriately adjusted in response to today’s lower rates. Bond yields do not go from, say 5% to 2.5% in a sudden and dramatic fashion that rivets attention and garners headlines, but today’s low rates are still a big deal with important implications for your portfolio.