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Portfolio > Mutual Funds > Bond Funds

Are Bonds Losing Their Defensive Edge?

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Many investors think of bonds as a portfolio’s defense. Since 1980, U.S. 10-year treasury bonds have performed like the vaunted 1985 Chicago Bears defense, creating offensive-like total returns of more than 8%, which had investors dancing the Super Bowl shuffle.

This impressive performance came from a blend of interest income and price appreciation from falling rates.

As we all know, though, victories from seasons past are no guarantee of future success (as all Bears fans still waiting for another championship will remind you). After 35 years, many investors are concerned that the bull market in bonds is getting a bit too old to play effective portfolio defense while continuing to deliver strong returns.

Rates are on a trillion-dollar race to the bottom

The bond bears are concerned interest rates could move higher or stay flat, creating holes in many portfolios since bonds would no longer be a source of portfolio returns. The bulls think interest rates will continue to fall as they did in Japan 15 years ago, which was to the benefit of Japanese bond investors.

However, the slow- to no-growth environment that lower interest rates created was a terrible environment for Japanese stocks. Now interest rates are moving into negative territory and Japanese investors are facing not just a “lost decade,” but what is becoming a “lost half-century.”

Despite the consequences experienced by the Japanese economy, many countries around the world are following a similar playbook that kicked into high gear after the volatility of early 2016. This has created a historic increase in the amount of money investors have lent to governments at negative rates. In fact, as of the end of May 2016, almost 40% of all global government bonds were forcing investors to pay for the right to lend money.

How much money? $10 trillion – and growing.

What if the U.S. follows the same playbook?

So what could happen in the U.S. should rates keep moving lower? If the performance of U.S. 10-year Treasury bonds have a similar run from now to 2050 to their performance from 1980 to today, this could create similar gains of roughly 4% per year.

But total returns would change if rates kept moving into negative territory — and following this theory, this could occur sometime in the year 2021. In the upside down playing field of negative interest rates, the lender has to pay the interest to the borrower every year. So most, if not all, capital appreciation would be offset by the interest payments.

The question is: How long would investors be willing to pay for weak defense?

There could potentially be real damage to the economy as well. Just like the Japanese stock market, U.S. equities could be battling a major headwind with negative rates. Money market funds could likely have to “break the buck,” forcing savers to pay for the right to keep money on the sidelines. It is difficult to imagine a world where homeowners are paid by banks to take out mortgages and investors pay junk companies to borrow money from them.

No matter whether the bond bears or the bulls are right, it is safe to say that the world would look a whole lot different if the next 35 years are like the last 35.


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