Why Not Bonds (Again)?
By: James C. Denton, CFP®, Managing Partner
July 26, 2019
In March of 2016 I wrote a newsletter titled “Why Not Bonds” (here it is), reviewing yield trends and other macro-economic considerations and concluding that the potential for bond investing was such that, while I didn’t use the words, bonds were more risky than stocks. Given that the most common reason people invest in bonds is to avoid risk, this created a conundrum. You usually don’t reduce risk by investing in more risky investments. [1]
This article is intended as a supplement to, an update if you will, of that article rather than a replacement, and I would suggest that you go back and take a look at it before proceeding further.
That article was based on an underlying if not fully stated belief that interest rates were at unsustainable levels. If I had been asked, I would have stated with some conviction (and probably did to some of you) that a change in interest rate direction was unavoidable, could have been imminent, and that once started, would potentially be drastic, rapid and ultimately, utterly value-destructive to existing bonds. I expected that at some point interest rates would begin to rise, that investors would demand higher yields to buy new bonds, that existing holdings would be dumped in search of higher returns, and that these factors working together would create a vicious spiraling effect that would destroy everything in the fixed-income realm in its path. Sounds like a bond market crash, doesn’t it, and that’s pretty much what I feared might be in the offing.
Happily, so far, I have been wrong. Why “happily”? Because the feared outcome, even if expected and prepared for, would have negative effects far beyond the bond market. Indeed, all investment markets, and therefore our portfolio returns even without bonds, would not have been nearly as good as they have been. No major economic event is ever contained within the sector in which it begins. And sometimes you just don’t want to be “right”.
Setting aside the historical considerations, which are only relevant for what we can learn from them, the more important issue is what should we expect from here. Will I ultimately be right at some point, and if so, is further preparation necessary? Do we need to do anything differently? Or will I continue to be wrong, and if so, what would/does that mean? Should we start buying bonds again?
I think it’s important to identify first whether I was really wrong or was I (am I still) just early. In other words, is the cataclysm I described above still out there somewhere. My view … It may be, but I am not as concerned now as I may have been in the past.
The reason for my potential misjudgment? I’m old enough to know better but I expect I may have made the same mistake that I watch all the young guys and gals make daily (almost everyone is young to me these days) … I assumed that the market would perform forever within the bounds of my own experience, rather than recognizing a longer-term view might provide a better perspective. More on this later.
Explanation: When I first started in this business in 1989, we were still in the very early stages of what has turned out so far to be a 38-year downtrend in bond yields. [2] The 30-year treasury – the ultimate benchmark for most if not all other fixed-income investments, topped out at approximately 14.5% in August 1981. By 1989 it had fallen to ~8%, and it has continued to fall steadily since that time (see chart here). At every waypoint along that trend line, more observers than not, myself included, have had a bias that the rates we were seeing at that particular point in time were “low”. The expectation throughout the 90’s and 00’s was that at some point we would, at best, level off at (then) current yields; as time has gone by, we have increasingly expected a trend-reversal back to a much higher level. Everyone had their own expected “normal” rate, to which we assumed at some point we would level off. But regardless of where one drew that line, the lower we went, the more we (I) feared that it was only a matter of time, and we (I) didn’t want to lock our investors in at a historic low point with both lower returns and liquidation value (as yields go up, the value of outstanding bonds go down). How’s it played out? The low point for the 30-year (so far) was ~ 2.2% in August 2016, and today it’s still under 2.6% as I write. [3]
What has caused this massive reduction in borrowing rates? That’s a long and complex discussion rooted in international macro-economic conditions, political considerations and investor decisions and reactions. You don’t want me to go there, it matters only that we are where we are.
The more relevant question is, “what’s closer to ‘normal’, or rather what will be normal over the next 30 years?” I don’t think anyone believes that the current sub-3% yields are in any respect enduring, but neither will you find very many who expect a return to anywhere near the 14%+ rates of the last cycle. And this is the point in which my own thinking has evolved the most over the past couple of years.
My view, for what it’s worth, is that that elusive long-term mid-range value is probably somewhat higher than where we are right now, but is a bit lower than I would have expected or predicted even a couple of years ago. If I get outside of that box defined by my own experience, I see a longer-term “normal” probably somewhere between 3.5 and 5.5% for the 10-year, a little higher for the 30, with periodic fluctuations outside of that range driven by the normal ebb and flow of, again, economic trends, political nonsense, and investor expectations and decisions.
The problem is we only have 34 years of actionable experience for the 30-year treasury. We don’t actually know if 14.5% is really a massively high rate, or if 2.5% is as low as the 30-year can go. [4] (Here is a history of 10-year rates back to 1871.) But history is exactly that – history; we can neither benefit from or be harmed by it. 100 years from now we may have a demonstrable range far outside of current boundaries, and the average may be 2% or 10%. How do you act upon that possibility? How do you decide whether and how you need to protect yourself from or take advantage of the opportunities that range of outcomes suggests?
Here’s your take away. I am only admitting to (or willing to entertain the possibility of) being wrong insofar as my expectations of interest rate directions and range. Ultimately, I do not expect the bond market crash as I once did, but the risk remains, and must be protected against.
I continue to believe, however, that bonds at current yields need to be avoided as an asset class for individual investors. Some capital gains have been realized by those who have held bonds over the past 30 years, but shorter term, those gains have been elusive to non-existent, and in most cases for the average investor, less by far than have been available from other investment opportunities. Regardless of prior experience, capital gains in bonds are almost impossible at current rates. And in any event, individual investors do not invest in bonds seeking capital gains. If you make a bond investment today, the absolute best you can expect to receive is 2.6% for 30 years, and your principal is only safe is you stay put for the full 30 years. Higher yields in corporate or foreign bonds bring higher risk.
You might ask, “Jim, when would you change your view?” At what interest rate would I consider bonds once again as a reasonable investment under traditional asset allocation practice? That’s a fair question and not an easy one to answer. We look at a lot of stocks that we do not consider reasonably priced at the present, and we assign target prices at which we might consider buying them. But when/if they ultimately reach the target value, a lot of things are different than when we made that initial assumption or valuation. The overall market – the prospects of the company itself – why did the price change – other investment opportunities, etc., the list goes on, and we may never find that stock to be a good investment. The same is true for bonds. Presently I might say I would like to see at least a 4 to 4.5% yield for a 10-year bond to justify tying up the funds for that investment. But I might decide when we get there that 4.5% or even something higher is not adequate.
It’s important to remember that bonds are almost always going to provide a lower expected return than other investments. Individuals buy bonds to diversify against the possibility that those other opportunities turn against us and have the expectation (under “normal” conditions) they will hold their principal value. So, if there is an alternative investment which is “uncorrelated” to equities and other investment classes, holds its liquidation value, and has a higher expected return than bonds, then the purpose can be served with that alternative investment, and bonds become less attractive, desirable or even necessary as an investment class. The question is always relevant and appropriate … “Why Bonds?”
I know I’ve droned on to the point that I’ve probably lost most of you by now. But there is another important take away here far beyond whether or not to invest in bonds. Very early in this discussion I admitted to making a “rookie mistake” in assuming that my own experience defined the potential range of market performance. This is a mistake we all are prone to, unconsciously to be sure, but real nonetheless. You’ve done it, it’s human nature, and it greatly impairs our decision making, both ways.
The 2000 crash was a direct result of investors of the time thinking the gang-busters experience of the 80’s and 90’s was “normal” and would continue forever. We learned the hard way that nothing is forever.
By 2010, we had a whole generation of investors whose experience was limited to, or at least largely defined by two major market crashes inside of a 10-year period. The result was (and continues to be) an inordinate fear that market crashes draining off 50 to 80% of portfolios are normal and always imminent. They are not. We may never have another of that magnitude in the lifetime of anyone reading this article.
Diversification does not guarantee against market losses, but it does increase your protection against 2000 or 2007-level events, while positioning you to take advantage of market gains like we saw in the ‘90’s if and when they occur. We are in the midst of one of those trends, by the way, but owing to the caution engendered by 2000 and 2007, we are a bit more circumspect in our expectations and actions, much to our benefit.
While I still have, and under any currently expected bond-yield environment, would have a visceral aversion to bonds, over allocation to equities or any other asset class is equally risky. It’s counter-intuitive, but “Modern Portfolio Theory” (current planning strategy) suggests that just adding different asset classes to your portfolio, even more risky ones, will reduce volatility, improve long-term capital preservation expectations and total return. For many of us, return OF principal is more important than return ON principal. I get it. Whether that’s true for you or not, any portfolio should include a component offering the protection that bonds historically have been expected to provide. What that means for you personally is another discussion, to be had one-on-one with your advisor.
[1] Actually Modern Portfolio Theory argues the opposite – the best risk-reduction strategy is diversification and diversification can be achieved with either lower- or higher- risk investments. But that’s a much more complex discussion than is appropriate here. I believe most would agree that one would hardly select an investment with both higher risk and lower potential returns just because it diversified their portfolio.
[2] This may be a primary fallacy in my reasoning. While some analysts suggest that rates still have room and reason to fall farther, there is evidence to believe that the downtrend ended some five to seven years ago (the 10-year bottomed out in 2012), and we have been in a sideways or “bottoming” pattern since. Hypothesis: perhaps we are just reverting to a historically consistent or sustainable range, i.e., perhaps we are back to or at least very near what in ten years or so we will consider to be “normal”.
[3] The >14% rate was by far an all-time record high for the 30-year treasury. The 30-year Bond only became available to the public in 1975, so longer term data is hard to come by, but here is a 54-year picture of the 10-year T-bill performance which I expect would closely approximate the shape if not the range of a 30-year bond yields for the same period. Anyone who lived through the “stag-flation” of the 70’s will say “oh, yeah I know why that happened”. The point is the high rates throughout the 70’s and 80’s were situationally driven, clearly anomalous, and should be discounted when developing long-term expectations. The question is whether the historically low rates we are currently seeing are equally anomalous – a mere over-swinging of the pendulum, or also situationally driven, and in either case, subject to correction back to some yet-unknown midpoint?
[4] sub-zero rates currently exist in developed economies around the world including Germany and Japan, a big part of the reason why our own rates are as low as they are.
The opinions expressed in this article are those of the author and may not reflect the views of LPL Financial. This article is not intended to provide investment guidance to any individual. You should review your situation and strategies with your personal advisor before acting on this or any investment advice. Any economic forecasts expressed or implied in this article may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. All investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.