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%.
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.
This economic battle has effectively waged war against retirees and near-retirees, while making the prospect of a secure retirement much less likely for everyone. Retirees typically look for lower-risk investments and for income from their investments. They are also generally wise to seek assured income in retirement so as to secure their future living costs.
The current interest rate environment makes the provision of guaranteed income and the receipt of reasonable yield or return on fixed income investments essentially impossible. During her Senate confirmation hearings to head the nation’s central bank, Janet Yellen acknowledged as much. “I understand savers are hurt by this policy,” she told senators.
What To Do?
This reality is pushing many retirees into far riskier assets like equities, junk bonds and alternative investments such as REITs, both traded and non-traded. Obviously, that kind of risk is, well, risky and thus dangerous for a retiree who is counting on that money to live and who doesn’t typically have the opportunity to go out and earn more money if problems ensue.
Insurance companies have created some excellent and innovative tools to provide guaranteed income, but they can have risks too and often come with high fees attached. Moreover, carriers are constrained by the interest rate and investment environments too. Yet the federal government sits idly by allowing a patchwork collection of state guarantee associations solely to bear the risk of backstopping these carriers in the event of financial difficulty instead of instituting an insurance equivalent of the FDIC, financed not by taxpayers, but by the premiums of member carriers.
Those saving for retirement face similar challenges. Finding promising investment opportunities is difficult — the risks in bonds are outlined above and equity valuations are high too — while “staying the course” is both more difficult and more fraught with peril as retirement nears. Investors nearing retirement ought to be taking risk “off the table” systematically and comprehensively to avoid sequence risk. But finding a reasonable investment choice for money that was in equities with acceptable risk parameters and the prospect of a decent return seems all but impossible.
It is understandable for the government and the Fed to want to get the economy moving again. But they don’t seem to be getting any bang for their buck — actually many bucks. For example, despite the crazy-low interest rate environment, bank lending remains down even though the financial crisis peaked eight years ago and corporations are holding exorbitant cash reserves rather than increasing capital spending.
Meanwhile, pension funds are also suffering in the current ZIRP environment. Over 90% of corporate defined benefit pensions — broadly dependent upon fixed income investments — were underfunded in 2015, according to Wilshire Consulting.
Crisis to Come?
The Retirement Confidence Survey from the private, nonprofit Employee Benefit Research Institute has gathered opinion data from workers and retirees as to what they believe their financial status to be for over 20 years. The most recent survey results, published in March, once again show that worker confidence in having enough money to live comfortably throughout their retirement years, while improving, is not very high. Only 21% of people are “very confident” about their retirement prospects while 28% lack confidence in their financial preparations for retirement. But even with those worrisome numbers, there is good reason to think workers don’t realize how much trouble they’re in.
According to the EBRI Survey, over 30% of workers have no retirement savings, and only 63% of workers are currently saving for retirement. Most workers overall and roughly one-third of workers age 55 and over have less than $25,000 saved. That data is terrifying, but it’s far from all that is terrifying.
Most people think that a $500,000 nest egg is a really good achievement. Lots of people with $500,000 in retirement savings feel rich. However, in today’s ultra-low interest rate environment, a half-a-million-dollar portfolio cannot be expected sustainably to provide more than $20,000 in annual income (and even that is far from assured). That’s nothing like rich yet lots of people are hoping to get by on even smaller nest eggs, which is of increasing concern due to there being fewer and fewer pensions available.
Indeed, less than half of all workers think they need to accumulate $500,000 or more by the time they retire to live comfortably in retirement. Plus, 17% feel they need between $250,000 and $499,999, while 26% think they need to save less than $250,000 for a comfortable retirement.
‘War on Savers’
At current rates, $500,000 purchases roughly $2700 per month (just $32,400 per year with no inflation protection) in guaranteed income via an income annuity for a 65-year-old male. Accordingly, there is very good reason to believe that people greatly underestimate the amount of money they will need to retire comfortably. This is yet another unintended consequence of ZIRP and the “war on savers” it has produced.
Low and negative rates are forcing legions of investors to seek higher yield, and in doing so, they are taking on more and more risk. Low rates are depressing savings and investment returns. Meanwhile, the Fed seems for and more afraid to return rates to more normal levels for fear that the entire financial system is now addicted to ZIRP. For savers and investors, the best news for the future and for their investments would be for the Fed to return to a more reasonable interest rate policy — and the sooner the better.