Bonds have historically provided great returns. Interest rates in the United States have been steadily falling since the early 1980s. Yes, that’s right, we have been in what is considered a 40-year bull market run in fixed income (i.e. bonds). This rally in bonds started when interest rates peaked in September 1981. Was March 2021 the official low, shifting us to a bear market?
The key interest rate to consider is the United States 10-year Treasury, which set a new low in yield back in March 2020 at just above 0.50%. Time will tell, but we may very well look back on the pandemic as the catalyst that ultimately ended the 4-decade bull market in bonds.
Bond prices have an inverse relationship to interest rates. As interest rates go lower, bond prices go up and if interest rates head higher, bond prices go down. Increasing bond prices means better performance of the asset class. If the benefit of a falling interest rate environment has subsided, it’s helpful to understand the dynamics that will drive bond performance into the future and the impact that could be felt in a portfolio.
As of writing this, the U.S. 10-year Treasury bond is hovering right about 1.20%. So, if you bought this bond today, the yield to maturity would be a rate of 1.2% per year until you ultimately received the principle back on the bond at maturity. To do better than 1.2% per year, you would need interest rates to drop from 1.2% to something lower for the bond price to increase.
The performance picture worsens when you factor in inflation – which has received a fair amount of press in 2021. In a period of stagnating bond yields and stable bond prices, inflation acts as an additional tax, robbing an investor of “purchasing power.”
A bond will pay an investor 3.0% interest over the next year and inflation is being measured at 2.0%. That bond’s inflation-adjusted return is only 1.0%.
This is NOT a call to sell all bond holdings. There are many reasons bonds are an integral part of a portfolio’s allocation, like mitigating stock market volatility. However, we must acknowledge that the last four decades of falling interest rates will likely not provide the same tailwind for bonds moving forward (let alone the next four decades).
Now is a good time to check your bond allocation. The classic 60/40 investment portfolio may not get you to your financial goals. The risks of being too heavily weighted in bonds are not always transparent. While bonds may not be as susceptible to the swings in stocks, the interest rate environment should not be ignored.
In either scenario, bonds may pose a serious dilemma for investors if the bull market in bonds is truly over. This threat is not always transparent, particularly for those using Target Date Funds in a company retirement plan, such as a 401(k). Investors who are over-allocated to bonds in fear of stock market volatility must ask themselves, “which asset class carries more risk going forward?”
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