Bonds Lose Their Defense

Bonds Lose Their Defense

Many investors think of bonds as a portfolio’s defense. Since 1980, U.S. 10-year treasury bonds have performed like the vaunted 1985 Chicago Bears defense, creating offensive-like total returns of over 8.0% and having investors dancing the Super Bowl shuffle.

This impressive performance came from a blend of interest income and price appreciation from falling rates. Rates have fallen so far that 10-year U.S. Treasury bonds are currently paying interest of less than 2%.

As we all know, though, victories from seasons past are no guarantee of future success (as all Bears fans still waiting for another championship will remind you). After 35 years, many investors are concerned that the bull market in bonds is getting a bit too old to play effective portfolio defense while continuing to deliver strong returns.

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In fact, many investors are already adding new types of fixed income to their portfolios in a search for yield. Unfortunately, the search for yield weakens their portfolio’s defense in the process. Higher yielding securities also come with much higher correlation to equities.

Chart source information is at the end of this post.

Rates are on a trillion-dollar race to the bottom

The bond bears are concerned that interest rates could move higher or stay flat. In this scenario, bonds would no longer be a source of returns, creating holes in many portfolios. The bulls think interest rates will continue to fall as they did in Japan 15 years ago, which was to the benefit of Japanese bond investors.

However, the slow to no growth environment that lower interest rates created was a terrible environment for Japanese stocks. Now interest rates are moving into negative territory and Japanese investors are facing not just a “lost decade,” but what is becoming a “lost half-century.”

Despite the consequences experienced by the Japanese economy, many countries around the world are following a similar playbook. This kicked into high gear after the volatility of early 2016, creating a historic increase in the amount of money investors have lent to governments at negative rates. In fact, as of the end of May 2016, almost 40% of all global government bonds were forcing investors to pay for the right to lend money.

How much money? $13 trillion – and growing.

What if the U.S. follows the same playbook?

So what could happen in the U.S. should rates keep moving lower? If the performance of U.S. 10-year treasury bonds from now to 2050 parallels their performance from 1980 to today, this could create similar gains of roughly 4% per year.

But total returns would change if rates kept moving into negative territory — and following this theory, this could occur sometime in the year 2021. In the upside down playing field of negative interest rates, the lender has to pay the interest to the borrower every year. So most, if not all, capital appreciation would be offset by the interest payments.

The question is: How long would investors be willing to pay for weak defense?

There could potentially be real damage to the economy as well. Just like the Japanese stock market, U.S. equities could be battling a major headwind with negative rates. Money market funds could likely have to “break the buck,” forcing savers to pay for the right to keep money on the sidelines. It is difficult to imagine a world where homeowners are paid by banks to take out mortgages and investors pay junk companies to borrow money from them.

No matter whether the bond bears or the bulls are right, it is safe to say that the next 35 years could look a lot different than the last 35.

Source: US Treasuries is represented by Barclays 1-3 Yr US Treasury TR USD, Municipals are represented by Barclays Municipal TR USD, Corporate is represented by Barclays US Corp IG TR USD, Foreign Debt is represented by Barclays Global Aggregate Ex TR USD,  Utilities are represented by DJ Utilities Average TR USD, Emerging Market Debt is represented by Barclays EM USD Aggregate TR USD, REITS are represented by the  DJ US Real Estate TR USD, High Yield is represented by  Barclays US Corporate High Yield TR USD, and High Dividend is represented by DJ US Select Dividend TR USD.

Index performance in this document was sourced from third party sources deemed to be accurate, but is not guaranteed. All index performance is gross of fees and would be lower if presented net of fees. Investors cannot invest directly in the indices referenced in this document.

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