Even race cars have seatbelts. And while most of us do not drive a race car, we recognize the benefits of wearing a seatbelt to protect us if we have an accident – even if we are driving at more modest speeds. Historically, investors have owned bonds in their portfolio which added a seatbelt like effect in the event of a market crash. And, even better, the bonds paid a coupon payment (interest) to the owner for holding them. I think of it almost like being paid to have insurance on part of a portfolio. However, with interest rates near zero, many investors – and advisors – are asking the question: “Should I still own bonds given that they no longer pay much interest?”
It is a fair question worthy of thinking through considering that most investors have some portion of their retirement savings allocated to bonds. And many investors who are at or near retirement have a substantial amount of their savings in bonds – earning very little. Over time, this can be very expensive insurance.
There was a time – not that long ago – when owning a broad-based bond index like the Bloomberg Barclays Aggregate Bond Index would allow you to earn 6-7% in interest. This is the essentially guaranteed coupon rate the bond issuer (like the U.S. Government or a corporation) pays to the bond buyer who is loaning them money for a stated period of time. Incidentally, the interest rate a bond pays is also referred to as a coupon rate because in the ‘old days’ the bond had coupons attached that the owner would clip to receive their interest payment.
In addition to earning interest on a bond, the bond owner can also lose or make money on the value of the underlying bond. In other words, if I buy a 10-year bond for $100 the bond issuer agrees at the end of 10 years to give my $100 back in addition to the interest I earn along the way. Let’s further assume the bond is issued by a corporation and will pay me 6% interest for 10 years until it “matures”. For this example, let’s pretend that in year 3 interest rates across the economy fall such that companies who want to sell 5-year bonds only have to offer 3% interest – instead of the 6% that I am earning. What do you think that does to the value of my bond? You’re right if you said it would become more valuable. Why? Would you rather own a bond paying 6% or 3%? Therefore, because my bond is paying a higher rate of interest than current investors can get, the price of my bond goes up above the $100 I paid for it.
Stated differently, as interest rates fall existing bond prices go up. If you want a visual, imagine the see-saw that children play on. When one end goes down, the other goes up. The same relationship is true with interest rates and bond prices. Further, if we look back to 1981 the Discount Rate was 14%. The discount rate is simply what the Federal Reserve charges other banks to borrow funds – and a good proxy for the overall level of interest rates at any point in time. Fast forward to 2020 and the discount rate is just 0.25%. In other words, interest rates have basically been falling for the better part of 40 years which has caused bond prices to go up. This decline in interest rates leading to higher bond prices has super-sized bond returns over the past several decades. This has been really good for bond investors.
That was then and this is now. How do things look going forward?
Well, with interest rates near zero, they really cannot go much lower. Some countries are toying around with negative interest rates which means you buy a $100 dollar bond, earn no interest on it and get back less than $100 at maturity. In other words, you would pay a company or government needing money to use your money and would be willing to receive back less than you loaned them for the perceived safety of their safekeeping. The United States Federal Reserve Chairman, Jerome Powell, has said they will not introduce negative interest rates in the U.S. Let’s hope so.
So, if interest rates are nearly zero and in theory cannot go any lower, what does this mean for bond investors?
- It means the interest payments that an investor makes from buying a bond (loaning money to a government or corporation) will be very low.
- It means that we can expect to earn very low rates of return on the “safe” portion of our portfolios for the foreseeable future. And,
- It means that when interest rates do begin to go up in the future it will be a headwind for bond investors. In the same way that falling interest rates make bond prices go up, rising interest rates make bond prices go down. So, if a bond is hardly earning any interest to begin with and then the price goes down, the total return could be negative.
As I write this, the 30-Day SEC Yield on the Bloomberg Barclays Aggregate is a measly 1.22% and a 10 Year U.S. Treasury is paying a paltry 0.85%. At the same time, the annual inflation rate according to the Bureau of Labor Statistics was 1.40% for the year ended September 2020. And this level of inflation is low by historical standards. What this really means is that the average bond investor will likely have a hard time beating inflation going forward given the current low interest rate environment.
What is an investor to do?
More conservative investors and those who are at or near retirement need some ballast in their portfolio to help protect against market declines and to have some safer money they can get their hands on during periods of market stress. Historically bonds have been the seat belt that helped offset the affects of a falling stock market. Even in today’s environment, I expect this relationship to hold true. Owning the right kind of high-quality bonds should help protect and preserve capital when stock markets are going down. However, the protection comes at a price.
Given that investors will earn next to nothing on their bonds, and possibly lose purchasing power when inflation is factored in, I believe investors would be wise to consider a couple of ideas for the future:
- Consider reducing the amount of your portfolio allocated to bonds. Use financial planning to determine what percentage of your portfolio equals 5 to 10 years of portfolio withdrawals in retirement. Then allocate that percentage of your investments to bonds and the remainder to stocks which I believe will have a better chance of making money going forward.
- Consider hybrid investments that can serve as a proxy for bonds in your portfolio. This is a slippery slope given these types of products run the gamut from total garbage to potentially compelling. There has been research done that illustrates using an insurance-based solution can provide a better chance of higher returns for your safe money which could help preserve your portfolio’s value. I would suggest doing this type of research and planning with a fiduciary advisor who has access to the newest generation of consumer friendly, no-commission products.
- Consider taking a portion of your safe money and buying an immediate annuity with it. Once retired, I would target the amount of income needed for the next 5 or 10 years. With this guaranteed income as a buffer, the idea would be to invest the remainder of your portfolio in stocks for longer-term growth. This assumes you could sleep at night during periods of high market stress with all of your investments (other than the guaranteed income stream) in stocks. This would be tough for some investors.
The right option may be some combination of all three. The real key is to understand that bonds as portfolio ballast can still be useful but will likely come at a cost to your overall investment returns. Anything that you can do to reasonably increase your chances for better returns while producing the income you need and most importantly enabling peace of mind around your financial future is the goal. As always in the world of personal finance, the right answer is rarely black or white but generally some shade of gray. Be sure you understand yourself and all your options before making any adjustments to your long-term strategy.