“History has not dealt kindly with the aftermath of protracted periods of low risk premiums”
-Alan Greenspan, Former Federal Reserve Chairman 1987 - 2006
Throughout my investment career, most investors have viewed bonds as the safer alternative to investing in stocks. Bonds are viewed by many investors as a low to moderate risk investment with a low to moderate return. That view is correct when looking at the long-term risk reward profile of bonds and stocks. If you look just at the past decade, returns on long and intermediate maturity bonds have been outstanding. The S&P US Treasury Bond Current 30 Year Index shows an annualized total return of 8.55% over 10 years, 10.45% over 5 years, 14.78% over 3 years, and 34.45% for the past year. As the economic conditions which created a 38-year bull market for bonds (e.g. falling interest rates) come to an end, I believe the risk of holding long-term and intermediate-term bonds is high and the probability of achieving positive real returns on these bonds are low. This risk is present for US Treasury, corporate and municipal bonds of intermediate to long maturities (10-30 years).
Investors who purchase bonds are given two promises by the issuer of the bonds: a series of fixed payments in the future known as coupons and payment of the face value of the bond at maturity. When holding a bond, you assume two risks: 1) interest rate risk where changes in market interest rates affect the value of your fixed payments and 2) default risk where the entity that promised the fixed payments is unable to deliver them. Let’s take a closer look at these two risks.
When market interest rates change after a bond has been issued, the value or market price of the bond changes. If market interest rates go up, the market price of the bond (present value of the cash flows) goes down. If market interest rates go down, the market price of the bond goes up. This relationship between market interest rates and bond prices has turbocharged the returns on bonds over the past 38 years as long-term interest rates have declined from a peak near 16% in the early 1980’s down to .69% as of July 1, 2020 (see chart).
Source: US Federal Reserve St Louis website (FRED)
The problem now is obvious after looking at the chart. If you purchase a 10-year bond with a yield of .69%, the only way you can increase that return is if interest rates decline from here. The problem being we are almost at zero now. Ask yourself if this a good time to refinance a mortgage. If you answer yes, it’s probably because you think rates are near or at a bottom. Unless you believe that we will get negative interest rates in the US, the bull market in bonds is about to run out of fuel. Fed Chairman Powell has said that negative interest rates are not an appropriate tool for us here in the US and I take him at his word.
You do not need much imagination to see the possibility of a time in the future when interest rates rise from current levels and this is where the damage occurs for long and intermediate maturity bondholders. What would that look like? Well if you own a 10-year bond with a 2% coupon and long-term interest rates rise from current levels by 2%, the market price of your bond will drop by 16.4%. If you own a 30-year bond with a 4% coupon and long-term interest rates rise by 2% from current levels, the market price of your bond will drop by 31.9%. When rates rise, everything else being equal, long term bonds drop more than intermediate term bonds and lower coupon bonds drop more than higher coupon bonds. Institutional investors who hold bonds are well aware of this risk. From my own experience, I do not believe that many individual investors who own long and intermediate term bonds are fully aware of this risk. When you have a 38 year long bull market in any asset class, people forget that not all investing stories have a happy ending.
The other risk that bondholders assume is default risk. This risk varies by the issuer. US Treasury Bonds effectively have no default risk since the United States Government has the ability to print money to pay their debts. Municipal bonds and corporate bonds carry default risks of varying degrees and many investors look to a bond’s credit rating as a gauge of this risk. Historically, one of the greatest threats to an issuer’s ability to service their debt is a deep economic recession like the one we are experiencing today. The recession creates pressure on a corporation’s or municipality’s ability to service their debt due to declining sales for corporations and declining tax revenues for municipalities. This risk will show up as a rating downgrade on a bond. When a bond or issuer’s credit rating is downgraded, the market price of the bond will usually drop to reflect the increased default risk on the security.
So, we have two headwinds, interest rates near zero and a recession caused by a pandemic, that are likely to pressure future returns on long and intermediate bonds. What might that look like? A leading quantitative research firm in California that combines future cash flow modeling and economic projections with computer simulations projects the annual real return on long term US Treasury Bonds to be -3.5% over the next 10 years. Their return projections are real returns which means they account for inflation and give you the true profit or loss of an investment. They project a real return on intermediate US Treasury Bonds for the next 10 years of -.8%.
The takeaway from all of this information is that the fantastic returns of long and intermediate-term bonds during the past 10 years are not likely to be repeated over the next 10 years. I do not pretend to know what future returns will be. As an investor, I try to position capital in asset classes where it is likely to grow or benefit from economic conditions and avoid asset classes where I perceive the odds are stacked against me. The bond market has experienced an incredible 38-year bull market, but all bull markets eventually end and turn into bear markets. If you wait until that is obvious to everyone, the pain can occur pretty fast. It is always best in investing to err on the side of selling too early as opposed to too late. This may be a time to heed the wisdom of the college student – no matter how much fun you are having at the party, make sure you leave before the cops show up.