When I was looking for my first investment-management job, one of the popular interview questions at the time was “Where would you invest your grandmother’s money?” This was a way to weed out those that had no idea what they were doing. Anyone with half a clue could concoct a story about a balanced portfolio built around a foundation of medium to long-term government bonds that would keep grandma rolling.
Today, it’s a much more difficult question to answer. The asset that has traditionally been at the foundation of millions of retirement portfolios is now whispered to be in a "bubble," just like technology stocks in 2000 or houses in 2007.
Luckily, future bond returns are in many views easier to analyze than future stock returns. To take a data-focused view of the safety of government bonds, we can look at three things: the current yield curve, the historical data, and the fundamentals.
1. The Yield Curve
While it is quite hard to predict the future returns of an equity portfolio with any accuracy, the returns for fixed-income are “fixed” under certain conditions. Hold a bond with a yield of 5% to maturity, and you will generate a return of precisely 5% a year. Since the yields for a variety of bonds are widely available, this provides a good starting point to talk about what Fixed Income returns might look like in the future.
The daily Treasury yield curve is available at http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield. As of May 2013, 10 Year Treasuries were trading at under a 2% yield. This means that if you hold a 10 Year Bond to Maturity, you will make only 2% a year in nominal (before inflation) terms.
While the nominal returns of a government bond is fixed and guaranteed provided that you hold it to maturity, the amount of real goods or services that you will be able to purchase with those returns is not. Inflation, or the increase in the cost of goods over time, is the bane of the bond investor. To be assured of real (after-inflation) returns, you should buy a TIPs bond. Unfortunately, the yield curve for TIPS (Treasury Inflation Protected Securities, which are adjusted automatically for inflation and are thus in “real terms”) is even more depressing. TIPS have been hovering around a negative yield all the way out to 20 years, meaning that investors that purchase a TIPS bond maturing 20 years from now and hold it to maturity are guaranteed to lose money in real terms.
2. Historical Data
To assure yourself of a return equal to a bond’s yield to maturity you must actually own it to maturity. Of course, if you sell it sooner than that, there is always the hope of getting a higher price than you paid for it and making money that way. Most investors get exposure to bonds through mutual funds. Mutual funds usually do not holds bond to maturity. If interest rates continue to go down, then the price of the bonds that a mutual-fund owns will increase, so investors might earn more than just a 2% return.
Of course yields can only go down so far. And the reverse is also true - if yields go back up, the price of long-term bonds may meaningfully decrease. Today, yields would seem to have a lot more room to go up then go down.
Looking at history might give us some idea of the range of returns that we can reasonably expect to see in a bond portfolio at a time like today. Since 1980, bonds have returned an average of 6% a year in real terms. Other periods have not been so kind to bond investors. From 1900 to 1980, government bonds produced a real return of only .2% a year.
Unfortunately, many investment advisors base their allocation decisions off of plugging average returns data for the last thirty or forty years into a “black-box” optimization program, which throws out the latter 80 year period and results in portfolios that are far more tilted to bonds than they should be.
Investors in other countries have been even less lucky. From 1900 to 1980 UK bonds lost .5% a year in real terms, an 80 “bear market.”
Those that still consider bonds a “safe” asset class also might want to consider this jaw-dropping statistic: from a peak in Dec 1940, US Treasury bonds fell 67% in real terms to their low in 1980. Investors lost a stunning 2/3 of their purchasing power over a 40 year period.
So does today look more like 1940 or 1980? Well in 1980 the 10 Year Bond hit a yield of 12.4%. In 1940 the 10 Year Bond hit a low yield of about 2.1%. Today the 10 Year has been as low as 1.5%. So 1940 would at least optically seem like a better guess.
3. “The Fundamentals”
Treasury Bonds are long-term loans to the US Government. When loaning money to someone, you should generally be concerned about their ability to pay you back in the future something equivalent to what you are giving them today. The United States has a $16 trillion national debt. It is adding to that debt at the rate of $1 trillion a year. It also has some $70 trillion in unfunded future liabilities, primarily promises of Medicare and Social Security Benefits to future retirees. So at first glance lending money to the United States government seems like it might not be such a good idea.
It is not clear that the political will exists to either raise taxes enough to pay for all the future promises the government has made, or to break those promises. This makes the stability of the system dependent on the ability to borrow ever-larger quantities of money, which means that the supply of government bonds is likely to continue to increase (partially offset by the Federal Reserve purchasing some of this additional supply with printed money). All else equal, increased supply leads to lower prices, since the government will need to entice more people to buy bonds in order to keep funding its operations. While "money printing" might be able to plug any funding gaps in the short-term, in the longer-term this can cause inflation, which is also quite bad for bonds.
At some point creditors who are funding the US debt (which includes foreign governments like China) might start to question whether the US is fundamentally capable of paying back all of its debt without printing money and debasing the currency. Once enough investors start to question this, then others will start to question whether more investors will start to question it... This kind of partially self-fulfilling “run on the bank” dynamic could produce a dramatic increase in yields akin to what has happened to Spain and Greece (with the crucial difference being that these countries cannot print money in their own currency to pay off their debt). Needless to say, this would be a very bad scenario for investors who bought into bonds or bond mutual funds at much lower rates.
Conclusion: Yields, History, and Fundamentals all point to a chance of danger ahead for bond investors
Market cycles are notoriously hard to predict. Many smart commentators have been calling for a bear market in bonds since the early 2000s and have consequently missed out on some of the best years in which to be owning them. There are a number of scenarios in which the great bond bull market could continue for even longer. There are even international precedents for this - Japanese 10 Year government bonds currently sit at a paltry and stunning .64% yield. If rates in the US are headed this low, bonds could still be a good trade.
But if you are a buy-and-hold investor with a time horizon of a decade or more, it may be time to rethink your portfolio from the ground up in light of a new world of dramatically lower expected returns and higher risk from government bonds. This “new normal” can impact everything from what your optimal asset allocation is, to how much you should be saving and what kind of lifestyle you will be able to afford in retirement.
Finally, if you have an advisor that has constructed your portfolio based the assumption that bonds will earn an average of 5% or more in the future (and if your advisor mentions anything about "Modern Portfolio Theory" then you probably do), then do yourself a favor and pick a different advisor, or better yet, start taking control of your own retirement. When investment fundamentals change, the right approach is to come up with new answers, not repeat the same tired and rote ones that got us through the last thirty years.
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