Investing at Bond Yield’s End

Investing at Bond Yield’s End

by Zach Marsh on May 21, 2021

One of the most common questions that I get asked is, “Where do you think the stock market is going?” While I understand it is human nature’s desperate need for answers and clarity during periods of heightened uncertainty, just look at the geo-politics in the 1930’s, but unfortunately answers are difficult to provide. However, I would posit that the question most important, and least asked by most investors is, “Where are interest rates headed?”

For the last 12 months the answer to that question has been higher. In August of last year the interest rate on the 10-year US Treasury bond bottomed at 0.5%. At that same time, the aggregate total of government bonds world-wide with negative yields topped $18 trillion, or roughly 30% of total government debt obligations. Currently, the yield on the 10-year US note sits at 1.61%, with the US re-opening and trillions of dollars spent on stimulus programs. Since rates bottomed in August, the stock market has largely been unfazed, with the S&P 500 rising over 28.5%. But while the bounce from 0.5% to 1.6% has been rapid, it has yet to definitively break what has been a steady 40+ year downward march in interest rates.

Declining rates imply rising bond prices. In September 1981, the 10-year rate peaked at 15.32%. Since that time, bonds have been in a 40 year bull market. I’m not willing, at this time, to declare the end of that 40-year trend, but I am willing to declare that the ability to derive significant real returns and/or significant real diversification from bonds is over. Real returns are what you eat after inflation takes its cut. The last Consumer Price Index showed a current inflation rate of 4.16%. That rate may be high and unsustainable at present time, but it seems like we are in store for rates higher than 2% in the future. An inflation rate of 2.5% and a 10-year bond rate of 1.6% implies a -0.9% real return—hardly an investment worthy of buying and holding to maturity. If buying and holding a 10-year bond almost guarantees a 1% annual loss on your investment, why is there any demand for this stuff at current prices, you may ask?

Unfortunately, the answer to that question would require an answer longer than I can commit to on this forum and much longer than you would be willing to endure. Suffice it to say, the Federal Reserve still plays a hand in controlling prices, even on longer-term obligations, and other investors may be looking to buy with the intention of not holding until maturity. For the latter camp bonds have ceased to be viewed as an income instrument and more of a risk-assuming, short-term capital appreciation investment. Long story short, if I bought a bond with a 1.6% yield to maturity and the market rate dropped to 0.6% the price of my bond will have increased in value by roughly 10%. Should I wish to capture that return at that moment I would have to sell it to realize my return. In other words, book a capital gain.

For most investors, who invest in bonds via mutual funds or Exchange Traded Funds (ETFs), essentially this is what you are doing—capturing returns on bonds, rather than employing the coupon income. Bonds are utilized as a counterbalance to stocks and have helped diversify investment risk. This approach has proven extremely profitable and sensible throughout nearly all of our investment lifetime, as bonds have done very well over the last 40 years. But with rates at rock bottom levels and a 40 year bull market running on fumes, we have to ask, “Can I still expect bonds to provide a ballast for my portfolio?”

The simple answer is unfortunately, not really. The last major bull market in US bonds ended in 1941. At that time, the 10-year yield bottomed at 1.95% in January 1941, eventually rising to that level mentioned earlier of 15.32% in 1981. If we compared the returns of a traditional 60% stock and 40% bond portfolio over the last 40 years to the returns of the same portfolio from 1941-1981, we find that the real return of that portfolio falls from 8.48% to 3.44%. If we shifted the allocation to 40% stock and 60% bond (similar to a recommended portfolio for retired investors employing passive target date funds) the real return from ’41 to ’82 was only 1.66%.

The implications of this conundrum can, or will, have profound impacts on pension funds and retirement savers alike. The answer to this problem is what drives our research and investment strategy development—how can we best solution a strategy to provide the real returns necessary to sustain an income strategy in retirement, a foundational giving organization, or helping younger investors receive the same investment opportunities their parents did. We feel that we’ve made significant headway via our adaptive, momentum allocation approach in solving a significant portion of this problem, but we understand that our job is never finished. Recently, we have begun rolling out more investment strategies aimed at driving future returns with less reliance on stock market valuations and bond price appreciation. We feel confident that these solutions can provide the necessary tools for the next 40 years.





Thanks for reading,

Zach and Dave





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