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When investors sit down to review how well their portfolio performed at the end of this long, strange year, they’ll be confronted with a fundamental question: Why do I own bonds?
The Vanguard Total Bond Market ETF (BND), for instance, is down almost 2% this year. If you assume inflation increased in 2021 by 5%, then BND has seen a real drop of 7%. Ouch. The outlook for 2022 doesn’t look much brighter.
It just doesn’t pay much to own debt these days. Yields on 10-year Treasuries remain absurdly low, at roughly 1.5%, pretty much where they were in April, when vaccines became widely available to all adults and experts were predicting a summer rebound. Given the ever-lengthening road back to normal, bond investors find themselves in a bind.
“I still own bonds, and I don’t really know why,” said Leuthold chief investment strategist Jim Paulsen. “I do it just because that’s what we’ve always done.”
In a recent research paper, Paulsen laid out why investors may want to rethink their devotion to this time-tested asset, which may no longer make as much sense as it once did.
The Truth About Low Bond Yields
The role of a diversified bond fund in your portfolio was always be something like a Zamboni: Smooth out the vicissitudes of the stock market. For most of the past century, investors could reduce their portfolio’s volatility without sacrificing very much in returns by adding a touch of bond exposure.
Here’s an illustration of the theory from the Great Recession. The Barclay’s Capital Broad bond index returned 5.2% in 2008, Burton Malkiel noted in “A Random Walk Down Wall Street,” while equities were obliterated. “There was a safe place to hide during the financial crisis,” Malkiel wrote.
Moving from a portfolio consisting of all stocks to one that had 10% bonds between 1926 and 2021, investors could have reduced their volatility by almost 2%, according to Paulsen, while lowering their total return by only 0.2%.
Given the current low-rate environment, Paulsen doesn’t think investors can reap the same benefits. The inflection point seems to be 3%. When bond yields are below 3% (as they’ve been since 2018), bonds lose their luster as a desirable place to park your money.
Paulsen examined average annualized real monthly stock and bond returns between 1926 and 2021 when the 10-year Treasury yielded more and less than 3%.
- When the 10-year yielded more than 3%, bonds returned 4.6% and stocks returned 6.8%. Bonds also saw positive monthly real returns 57% of the time, which was just one percentage point less than stocks.
- When the 10-year yielded less than 3%, as it does now, things were much grimer. Stocks enjoyed a 14% inflation-adjusted return while bonds gained exactly 0%. Meanwhile stocks only dropped 35% of months, compared to 49% for bonds.
How Much Longer Will Bond Yields Stay Low?
It’s going to take some time for bond yields to get up off the floor.
The 10-year yield has flirted with 3% ever since the end of the Great Recession. The last time rates were above this level was when the Federal Reserve raised interest rates throughout 2018, though that spate of monetary hawkishness quickly ebbed.
Heading into 2020, the 10-year was just 2%, thanks to perceived low economic growth over the long haul. After all, the nation is aging, and there has been insatiable demand for bonds, no matter the yield. Inflows to bond funds outpaced that for stocks, even as the S&P 500 was going gangbusters over the past 18 months.
And then there was Covid-19. After the pandemic began and state governments implemented social distancing restrictions, the economy fell off a cliff. The Fed responded by buying trillions of dollars of bonds (among other measures), which further tamped down yields.
Every time there was a rise in Covid cases, or a new variant was discovered, bond yields dropped further as investors fled to safety. (Bond prices and yields are inversely related, meaning as demand for bonds grows, their yields shrink.)
The Fed has already decided to buy fewer bonds, and it will eventually increase interest rates (perhaps in 2022), which could help push longer-term yields higher.
“Ultimately it gets back to that level,” said Paulsen. “But it’s not going to happen overnight.” All of which means we could be in this low-rate environment for a while longer.
Do Bonds Ever Make Sense in a Low-Rate Environment?
Which gets back to Paulsen’s question: Why own bonds at all until that happens?
Investors like the idea of bonds because there’s really no asset class that does what they historically have done: Secure your capital and generate modest returns.
Cash, for instance, will protect your capital, but you’ll lose purchasing power over time thanks to inflation. Treasury Inflation-Protected Securities (TIPS) can have negative yields if delation rears its ugly head, while commodities and gold can diversify your equity holdings but “bring different risks to the party,” Paulsen noted.
What’s an investor to do then? Maybe just own fewer bonds. “I wouldn’t sell everything overnight; that’s just too radical,” Paulsen said. “But I would move a little in that direction.”
If you’ve been more comfortable in a 60% stock/40% bond asset allocation, perhaps consider shifting it to 75% stocks and 25% bonds—just beware that you’ll be getting more volatility in your portfolio. If you like the bond income you receive, you may want to explore other ways you can lock in a stream of income.
“Guaranteed income through an annuity is a good alternative for some folks,” Libertyville, Ill.-based certified financial planner (CFP) Faron Daugs said. “You’re in bonds for income, not the appreciation.”
None of these are perfect options and may grate against investors who want to coast off the yield their investments have generated without taking on that much risk.
But these are different times, and you can’t let the perfect be the enemy of the good.