You may think that with all the exciting headlines on the price action of Bitcoin and the tax reform act that bond allocation could be a ‘less than exciting’ subject. However, I get more questions like the one above most often and it impacts many investors more significantly than the more ‘exciting’ topics. It seems that the topic may be even more on investor’s minds recently, given the rising valuations of the equity markets, as they may be wondering if it is time to re-allocate some of their equity gains toward the bond market. However, answering questions about bond allocations is not as easy as it once was. The reason is that many of the bonds that most investors normally invest in are now paying low yields and can contain more risk than investors understand. U.S. government treasuries, agency mortgages and investment corporate grade bonds primarily offer between 2-3.5% yields. If we factor in the effect of taxes and inflation on these investments the actual return investors are getting on these investments may be close to zero in ‘inflation-adjusted’ returns. This could mean that many investors’ portfolios could struggle in their performance in the future.
How did we get to a place where bonds that have averaged approximately 6% over almost 60 years now provide such low yields? A predominant factor is that our Federal monetary (as well as other developed countries) policy has been extremely aggressive. The Fed has bought $2.5 trillion in treasuries and $1.8 trillion in agency mortgage backed securities since 2009. At the time they initiated this ‘Quantitative Easing’, they had less than $1 trillion of these investments. This means they increased their holdings over 300% which drove the prices up and the yields down for these instruments. While investors would normally be motivated to put money in these investments to receive a reasonable return, the Fed had a different motive. They were more concerned on first stabilizing the financial markets and then supporting the economy. However, by doing so they have skewed the prices upward and have driven down yields on investments that many investors own. Unfortunately, many investors have not ‘gotten the memo’ and continue to invest in them in the same amount or more since that’s what they have always done, continue to be advised to do and in many cases these investments are all that are available to them in their retirement plans. However, it is anticipated that these ‘traditional’ investments will produce much lower returns than they historically have. Given that these are usually a significant allocation of investors’ portfolio I anticipate that this dynamic will act as a drag on portfolio performance going forward.
Let’s look at an example that I hope will explain why I think now is an especially good time to invest a lot less in these traditional bond investments. Let’s say an investor put $10,000 into a 10-year treasury note. They would receive a yield of about 2.4% ($240 annually) on the principal if they held it each year until the 10-year maturity. Unfortunately, this 2.4% yield is not much more than inflation is at this time (around 2%) and if this instrument was held in a taxable account then income tax would be due each year as well. So, between inflation and taxes we might consider this investment to be worth far less than the 2.4% yield it provides, say closer to -0- in ‘real’ (inflation -adjusted) dollars. In addition to this, investors may likely see the balance of the $10,000 investment in these investments fluctuate quite a bit if/when interest rates move back up.
Let’s say interest rates moved up 1% while holding on to this investment. Given that investors would then be able to invest $10,000 into a treasury note bearing a 3.4% yield they would pay the original investor less than the $10,000 they paid for the note yielding 2.4%. The exact amount could vary a bit due to timing but at this point the price adjustment would probably be around 6%. So, the $10,000 investment into a 2.4% yielding bond would probably fluctuate down to about $9,400.00. Please note that if investors held the investment until maturity they would still receive the $10,000.00 investment back but each year it was held there would be a lost opportunity to invest for higher yields. Realistically, in the current environment, the 1% move probably wouldn’t happen all at once but it could occur over time. While rates could of course go down and the principal on that investment would go up, I would not anticipate that these lower rates would last for long due to factors that I anticipate will put pressure on interest rates to rise. These factors include an economy that is doing well, the Fed has begun, (and have stated they will continue to) raise rates and inflation has also been slowly increasing.
Given that many investors own as much as 30% (or more) of these or similar low coupon paying investments in their portfolio it is easy to see how these investments could create a drag on performance. For now, we are ending a year (2017) where the equity returns have been great, so the lack of performance on the bond allocation in a balanced portfolio may not have been that noticeable. If the bond portfolio allocation was 30% and these investments produced a 3% return the contribution from these investments may be around 1%. If the rest of the money was invested in stocks within the S&P500 that allocation might have produced a 20% return. So, the balanced portfolio would still produce a return of approximately 15%. I think most of us would consider this a very good annual return.
However, the outlook for future S&P 500 returns over the next five years appear to be much lower than what we’ve just experienced. This is due to the run up in equity valuations which are historically high. In addition, we have gone a long time without a significant slowdown, so it would not be unreasonable to think we will experience this in our economy sometime in the next 5 years. For now, the domestic and global economy look good, but of course we know that times like these don’t go on without corrections along the way. So, let’s say the equity markets returned only 5% on an annual basis (believe it or not the S&P500 went through a whole decade producing far less than this from 2000-2009) and the bond allocation still produced about 3%, then this could result in a return of about 4.5% annually in the allocation mentioned above. These are not the kind of returns that we have recently become accustomed to.
It should be noted that holding some of the conservative hi-grade bonds as an ‘insurance policy’ to reduce risk in portfolios is still prudent. These investments usually perform well during times when the market perceives the odds for a recession is high. When the equity markets correct 10% or more due to economic conditions, these conservative bond investments can tend to hold up very well. However, there is another possibility that needs to be considered as well.
We are in an extremely low interest rate environment which has benefited the corporations’ profits and subsequently their stock price. As corporations re-financed their existing debt to lower rates, this increased the amount that went into profits. In addition, many corporations used this as an opportunity to borrow at low interest rates and use the proceeds to buy back their stocks since the cost of funds to borrow was cheaper than the cost of their equity. This increased the demand for their stock thereby driving those prices higher as well. So, to bottom line things a bit. By buying an inordinate number of treasuries and high-grade income investments the Fed has created a lack of desirable investment options in much of the bond market. This has ‘spilled over’ into other markets as ‘cheap money’ has helped to fuel an economy but also has acted as support for other investments such as equities or higher yielding investments as well. If interest rates rise faster than expected, the equity markets could be disrupted as well as investors would look to re-evaluate company’s equity prices given these higher rates could dampen future company profits and demand for their stocks. Then, also due to the rise in interest rates, the bond allocation, as previously discussed, would also not perform well.