invest in bonds

With yields so low today, it makes sense to invest less in bonds, but not to abandon them altogether.

One could be forgiven for asking whether it makes sense to invest in bonds today. Historically low interest rates may appear even lower for investors who realize buying bonds is the same as buying or making loans. For example, the 10-year Treasury is a loan to the federal government for 10 years, which today carries an interest rate at 1.82%. That rate seems lower when you consider federal income taxes are assessed on that yield. An investor with an effective tax rate of 30% will therefore receive 1.27% (or 70% of 1.82%) in after tax yield. Moreover, this is a nominal yield and doesn’t account for inflation. An average inflation rate going forward of more than 1.27% means that over the course of 10 years your money would lose some in terms of purchasing power.

Higher risk. Lower return.

Besides inflation risk, there are other risks for which this paltry yield would have to compensate you—or not—including credit risk, or the possibility the borrower can’t or won’t pay in the future. Investors also face interest rate risk.  Real interest rates could rise, which often happens when economic conditions improve and investors find better return prospects in stocks and other assets and therefore demand higher compensation for tying up money in a loan, especially a long-term one. 

invest in bonds

If you believe risk and return is largely a function of price (you should), then bonds are riskier than they used to be. In a way, they are priced for perfection: a future of low interest rates and inflation where everyone pays their bills. Why should investors have any bonds at all?

First, interest rates could continue to fall. Almost no one believes this, but it is true. Lower rates aren’t in our forecast; we think there is a good chance rates rise from here. But the thing about interest rates is they are very hard to predict. The Wall Street Journal Economic Forecast Survey collects forecasts from over 60 economists (most of them from Wall Street) on a variety of economic data, including the 10-year Treasury yield. At the start of 2019, the 10-year had a yield of 2.68%. At that time, hardly an economist forecasted a drop in the 10-year yield much less a significant one. As I write this on November 7, the yield stands at 1.82%, far from the average 12-month forecast of 3.1%. (And no one was even close: the range of forecasts was 2.50% to 4.18%.)

If you don’t think yields can go any lower, just look at Europe and Japan, where yields are much lower than the U.S. and even negative—which means some governments, corporations, and even mortgagees get paid to borrow today. Or, remember the Greek drama of 2009-2016? The country almost failed, but today the Greek government borrows at lower interest rates than the U.S. government. The U.S. is considered “high-yield” today, but there is no guarantee that lasts.

The role of bonds probably should be less prominent in portfolios, but they shouldn’t be altogether abandoned, especially for conservative investors. 

Bonds still play a role when it comes to deflation risk. An economic slowdown or recession is bound to happen, perhaps soon if history is any guide. With slowdown or recession, investors would likely accumulate bonds, especially high-quality and longer-term ones, and prices would rise as yields fall. (Remember, yields and prices go in opposite directions.) Bonds aren’t just for yield, they are also for capital appreciation.

For example, if the 10-year Treasury, now 1.82%, falls 0.50% (or 50 basis points) over the next six months, the bond’s price will rise about 10%. The yield/price relationship is even more dramatic for longer maturity bonds, like the 30-year Treasury. A fall in yield of 0.50% over the next six months corresponds to price appreciation of almost 20%.

Bonds as part of a diversified portfolio.

If all of this is true, then so is this: Bonds still promote diversification. Bonds, especially high-quality, liquid, non-callable bonds are a separate asset class that still has a low correlation to stocks and other asset classes. How long this relationship holds, we don’t know, but there is a good chance it holds for a while going forward. Think of bonds today as a role player with a specific hedging purpose.

It is said diversification is the only free lunch when it comes to investing. However, it can be discomforting to execute in practice, investing in things that might look unappetizing by themselves. Just remember, being diversified means there should always be something in your portfolio you’re not enthusiastic about; something in the portfolio that is doing poorly.

To be sure, the higher prices and lower yields of bonds means it also makes sense to have less exposure. We think many areas of the bond market, including many foreign bonds and “high-yield” or “junk” bonds look incredibly expensive and even un-investable. There are likely more opportunities in other asset classes, including stocks. Stocks generally are not cheap today, but their earnings, dividends, and growth attributes make them relatively attractive, especially over time. Investors get an earnings yield of 5.5% in the S&P 500 and a dividend yield of about 2% (and with preferable tax treatment). Not bad in a world lacking reliable sources of income.