Social unrest, unemployment, COVID 19, the election… there are a multitude of items we could address in our October update.
While there are a multitude of things we could address, I want to focus today’s discussion on the bond market. The reason why I want to focus on bonds is because bonds play a critical role in running a balanced portfolio.
The inverse relationship that stocks and bonds have experienced in the past has allowed investors to structure portfolios with higher levels of stability. That’s because bonds have historically acted as a shock absorber. When stocks were down, bonds were usually up and when stocks were up, bonds were oftentimes down.
However, the “shock absorber” role that bonds have played to offset stock market risk can no longer be relied upon, so this requires a major shift in our thinking.
With stock market valuations near all-time highs, the risk of a stock market correction is heightened.
The fixed income side of a balanced portfolio (the bonds) will no longer provide protection against a correction in the equity markets.
Declining rates have removed most of the income from bond portfolios and have added significant risks if rates were to rise.
Bonds (and “balanced portfolios” that hold bonds) may face significant headwinds in the future.
Finding solutions to this real problem is key to achieving your long-term goals.
As global interest rates have declined over the past 12 months, the search for income has become incredibly challenging. We believe that one of the biggest sources of protection to the traditional 60/40 portfolio (60% stocks, 40% bonds), has now become a risk.
A 40% allocation to a mixture of Treasury bonds and high-quality corporate bonds has historically served investors well. That’s because bonds were effective at creating income, providing a diversified source of return and providing capital preservation in times of uncertainty. But we believe core fixed income is not equipped to meet these goals going forward. After four decades of declining interest rates and the massive fiscal and monetary response to the health crisis, rates are hovering near zero throughout the world. Not only do low rates rob investors of needed income, the historic assumption that bonds will provide a form of protection is no longer valid.
If you search for income in today’s bond market, prepare for a long, unfruitful journey. Domestic and global bond indices yield between .6% and 1.2% across the globe.
Where exactly is the income in core fixed income?
Rates have steadily declined for the past few decades, but have significantly
declined over the past 12 months — and there is little room left for rates to fall much further
Rates have been falling for nearly four decades, but the collapse in interest rates over the last 12 months have left little room for rates to fall much further. The end result is that bond prices have a limited capacity to rise. Not only is there little room for bond prices to rise, there is tremendous room for bond prices to fall, especially if interest rates rise in the future.
In the interest of full disclosure, rising interest rates in the near term is not a major concern of ours. We are simply stating that there is significant downside risk with little upside reward. This can be observed by the chart below. If rates rise, all the return that was recently captured by the bond market from price appreciation (the black area), is likely to be given back by price depreciation.
Interest rates can do three things in the future. They can go up. They can go down. Or they can stay the same. If rates stay the same, we collect a paltry 1% yield on our bond portfolio and our bond prices remain stable. If interest rates go down, we collect the 1% yield with a small amount of price appreciation (because rates cannot fall very far from 1% unless they go negative). And if they go up, we collect our 1% yield, but we are subject to significant risk of price declines.
Not a whole lot of upside, but quite a bit of downside risk!
Unlike stocks, which theoretically have unlimited upside potential, bond returns are capped by the amount of interest income they produce over the life of the investment.
For example: If you bought a 10-year treasury with a 5% yield back in 2000, your bond would produce 50% income over the 10-year life of the bond (10 years of coupon payments * 5% yield = 50%). If rates were to go to zero, your bond would go from a price of par (100) to 150. It could not go above the 150 unless rates went below zero.
If you bought a 10-year treasury bond in today’s world at a 1% yield, and interest rates dropped to zero tomorrow, your 10-year treasury would now be worth 110 (1% yield for 10 years in a 0% interest rate environment = 10 points of price appreciation). Your bond could not go above 110 unless interest rates dropped below zero.
If instead of rates falling, rates began rising, that price change we just described would turn into price depreciation. And bond prices have way more room to move down rather than up when you are beginning at a 1% yield. That is why bonds have higher levels of risk today than ever before.
But it’s not just bonds that have increased sensitivity to interest rates. The performance of the tech and consumer discretionary sectors have also benefitted from our low-rate environment. These sectors now make up a much larger portion of the overall market, and that means that equity portfolios may also be sensitive to rising interest rates.
Bonds have been a pretty effective hedging tool against past stock market corrections. When equity markets experienced signs of turmoil, central banks generally stepped in to lower rates, and bond prices responded positively to the new, lower interest rates. We believe that this relationship can no longer be relied upon, because there’s very little room to lower rates further. That means one of the most-valuable diversification benefits of holding bonds is severely diminished.
It’s very difficult to accurately predict future inflation, but we can say this: if inflation were to resurface, bonds will not do well. The paltry income will not offset the purchasing power risk, and bond prices will decline when interest rates rise.
With interest rates near zero, the upside of holding bonds is low, and the downside of holding bonds is high.
The one reason to hold high-quality bonds in today’s environment is that they will be one of the few assets to hold their value if we see another significant equity market correction. In times of uncertainty, high-quality bonds will always be the preferred asset.
While that is a very good reason to hold bonds, the other risks of holding a traditional bond portfolio have become too great to ignore. Not only has income diminished significantly from a traditional bond portfolio, bonds may no longer provide the needed buffer during times of economic turmoil and they face greater downside risk in scenarios when interest rates rise.
If core fixed income is no longer able to serve the role it has played in the past, investors will need to use different approaches to accomplish their goals. If you would like to explore options that can help reduce the risks we mentioned here, register for our November webinar or schedule a no-obligation 20-minute strategy call and we can provide more insight into potential solutions.
THE HIGH RISK
OF OWNING BONDS TODAY
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