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September 26, 2016 at 08:00 PM
The current bull market in bonds dates back to September of 1981. U.S. Treasury 30-year bonds yielded an astounding 15.32% then. In October of that year, U.S. Treasury 10-year notes reached their high yield of 14.68%. With just a few blips along the way, it has pretty much been all downhill for fixed income ever since — for a remarkable 35 years.
To provide some context, consider that during those couple of months 35 years ago, Ronald Reagan was still early in his first term as president. “Raiders of the Lost Ark” had just been released during the summer. Sandra Day O’Connor took her seat as the first female justice of the U.S. Supreme Court.
The world’s first cell phone system was inaugurated (Nordic Mobile in Sweden). The Ayatollah Ali Khamenei was elected President of Iran. The Dodgers beat the Yankees in the World Series. Metallica was formed. I was among roughly half a million people in New York’s Central Park for the Simon & Garfunkel reunion concert. “Endless Love” topped the charts. “Dallas” led the television ratings.
In the financial world, Home Depot brought its IPO to market on the NASDAQ at $12 per share. A $1,000 IPO investment would be worth over $5 million today.
Quite obviously, a lot has happened since this extended bull market in bonds began three-and-a-half decades ago. Much has changed (even though Metallica is still touring).
As I write this, the yield on the long-bond is roughly 2.25%; the yield on U.S. Treasury 10-year notes is just over 1.5%. That’s a long way from 15.32% and 14.68%. There isn’t much room for further price appreciation today, and yields are anemic at best.
Starting from such low yields means that, after adding a reasonable inflation forecast, the real expected return on U.S. Treasury paper is effectively zero. Bond yields, which are roughly equal to their expected nominal return, are so low that the current environment has been characterized as one of “financial repression” by Larry Siegel of the CFA Institute Research Foundation and Tom Coleman of the University of Chicago in that current rates are depriving the economy of one potential growth area via income from savings.
Still, as Andrew Miller, CFA, CFP, has explained, bonds have historically provided some diversification benefit during really bad periods for stocks, and plenty of voices today are expecting the same going forward. However, most excess performance in bonds has been driven by the income-return component and not by their price appreciation, which makes their diversification benefits in a very low interest rate environment problematic at best.
Potentially worse, if the owner of a freshly printed 10-year note paying 1.5% were to see the market rate on that holding one year later rise 100 basis points to 2.5%, its price value would drop about 8%. Similarly, if the owner of a freshly printed 30-year bond paying 2.25% were to see the market rate on that holding one year later rise 100 basis points to 3.25%, its price value would drop by nearly 20%.
Bond Blues
Those facts suggest there are good reasons to be concerned, and plenty of people really are concerned. According to the recent CFA Institute Financial News Brief poll, 87% of its 815 participants believe that owning at least some types of fixed income no longer makes sense.
To put a finer point on it, 30% of respondents believe all bonds are in bubble territory. Another 24% see a bubble in sovereign bonds and at least one other class of fixed income; 14% of poll participants think that only high-yield bonds are over-inflated. When combined with other classes of bonds, 54% of poll respondents view high-yield bonds as in bubble territory. Meanwhile, only 13% don’t see a fixed-income bubble anywhere.
Since the start of the great bond bull market (1981-2015), investors in 10-year U.S. Treasury notes have, on average, earned well over 8.5% annually in an instrument that is, at least in definitional terms, risk free. Only five of those 35 years have seen negative returns. Long-bond investors have done substantially better.
But the real risks of U.S. government paper are all too apparent to current investors. We may continue to assume no default risk (despite what has been said during the current political campaign), but interest rate risk, inflation risk and duration risk are in fact real risks.
If we look 10 and 15 years out from historical rates at levels similar to those at present, annual returns have been less than 2% per year, on average, even before inflation. The average and median real (inflation-adjusted) returns for yields under 3% over 10- and 15-year periods are actually negative while even the best performing years are only slightly positive. Clearly, the next 35 years are very unlikely to be nearly so kind to investors in long-term bonds as the previous 35 years have been.
That said, rates don’t have to rise. Indeed, the Federal Reserve has shown remarkable resistance to raising rates from these exceedingly low levels. The Fed’s ZIRP (“zero interest rate policy”) is designed to stimulate economic growth and to provide support for the stock market. But the anemic growth we have seen since the financial crisis has not been able to accelerate, convincing the Fed to keep fighting to maintain low rates.
