By Marc Odo, Swan Global Investments
Will Bonds Continue Fulfilling their Dual Role?
An allocation to fixed income has traditionally been present in all but the most aggressive of portfolios, with conservative portfolios often being 100% fixed income. Certainly, many portfolios have benefited from their allocation to bonds over the last 35 years. But the wise investor should look forward, not backward, to determine if bonds will be able to deliver the dual role they have typically served.
But to look forward, we must examine the state of bonds today.
High Demand for Bonds
Yields have languished at historic lows and are slowly beginning to rise, but the demand for bonds has remained quite high ever since the credit crisis of 2007-08.
And why wouldn’t the demand be high when the following drove investors to bonds:
- Investors’ fears of equity markets in the 9+ year bull market
- Non-U.S. central banks maintained a healthy cushion of current account reserves
- Open market operations by the Federal Reserve Bank (i.e., “quantitative easing”)
- A very accommodative monetary policy
As demand for bonds has soared, the yield plummeted. As every student of finance knows, the yield on bonds is inversely related to its price. While the Fed eventually started a policy of tighter monetary conditions, the overhang from a nearly a decade of loose monetary policy still haunts the market.
This has left bond investors with an unattractive set of options:
- If rates stay low, bonds are unlikely to generate enough income to meet their spending needs.
- If rates increase, current bond holdings are susceptible to losses in value.
The Income Challenge
Historically, investors averaged 6.25% from Treasury bonds over the last 40 years. With rates roughly a third of that since the Financial Crisis, many investors were forced to reach for yield in riskier assets.
Think about it…at a 6.25% yield, a million-dollar position in ten-year Treasuries would produce $62,500 per year, or $625,000 over a decade. Alternatively, a 2.50% yield would produce only $25,000 per year. That’s roughly the definition of poverty-level income for a family of four….and that’s on a million-dollar portfolio.
So investors should welcome an increase in rates, right? With an increase in rates, a decrease in value follows threatening the capital preservation role of bonds.
The Capital Preservation Challenge
Bonds have historically been able to provide not only capital appreciation but also capital preservation. Over the last 35 years (Jul 1983 – Jun 2018) the investment grade bonds of the Barclays U.S. Aggregate Index have averaged an annual rate of 7.03%. The graph below shows why.