Not you right? I mean rates are clearly going to rise and bonds are going to go down quite a bit… Well, I don’t know actually. For example, from the mid 1870s through the mid 1960s, about 90 years, the US 10-Year Bond had a yield that fluctuated between 2% and 5%. Could that happen over the next 30, 40, 50 years? Why not.
A better way to think about it is what role do bonds play in your investment portfolio anyways? Sure, when looking at bonds in isolation it’s clear to see that the potential risk/reward is not the same as it was 3 decades ago, but the same could be said for U.S. stocks and we still seem to be liking those these days.
The real question is can they still make sense in a diversified portfolio? Let’s try and figure it out…
Below is a table I put together that shows the relationship between 10-Year U.S. Government Bond returns in years that the Total Return (TR) of the SP 500 was negative.
Here are some of my takeaways after doing this exercise:
- The SP 500 has had a negative total return in 24 years since 1928 (27% of years)
- In those 24 years that were negative, the total return on U.S. 10-Year Government Bonds was positive 21 times (87.5% of years) and has exhibited a -0.03 correlation during the 24 years that the SP 500 was negative.
- A higher starting yield has translated into higher total returns for U.S. Government Bonds in those negative years for the SP 500, but on the average, the difference was not as large as I anticipated. Using a starting yield of 5%, when it started a negative year above that, the bonds returned an average of 5.97% versus 4.99% when they started below 5%.
- When the starting yield was taken out of consideration and we look at just price movement, the picture changes. In terms of just price movement, not total return, U.S. 10-Year Government Bonds were positive in just 14 years (58.3% of the time). This is because U.S. Government Bonds returns come from their starting yield AND get amplified or decreased by interest rate movements. In those 24 years that the SP 500 was negative, price movement was responsible for 43% of the total return while the starting yield was responsible for 57%.
- When we look at the the differences between the “Rates Rise” and “Rates Fall” data, the level of diversification provided by U.S. 10-Year Government Bonds when rates rise is much lower than when the opposite is true. This was no big surprise, but the end return numbers were a bit larger than expected. The total returns during these two types of environment are vastly different (1.47% versus 7.69%). The issue of course is that predicting interest rates movements is a fools errand, so proceed with caution when going that route.
- Looking at 2000, 2001 and 2008, it is clear that those are outliers when looking at the long-term historical relationship between stock and bond returns. The rate declines in those years are 2-3.5x the average decline. Now the hard part is deciphering if that is the “new normal” with Central Banks playing this back-stop role in market decline/recessionary environments or if they truly are outliers? It’s anyone’s guess, but even if we exclude those three years, the average total return becomes 3.65%. That is still a respectable hedge making U.S. 10-Year Government Bonds a useful diversification tool.
- What should not be lost in all of this is that even in rising rate environments, U.S. 10-Year Government Bonds still acted as a decent hedge against market downturns. The average total return of 1.47% is not anything to get too excited about, but the bonds still did their job.
- The largest annual total decline for U.S. 10-Year Government Bond during a down year in the SP 500 was -5.01%. Things could be a lot worse than that…
I should also point out that U.S. Government Bonds are not the only hedge against market declines historically. This article from the gang at Alpha Architect is a good overview of some of the other assets/strategies that have performed well in historically bad markets. Although some of these other assets and strategies are a bit more complex for newer investors, it is important to find assets that you are comfortable holding for very long-periods and that help enhance the diversification of your portfolio. For some that may mean only U.S. Government Bonds, while for others it may mean U.S. Government Bonds plus some managed futures and/or quality stocks. Be diligent and understand your portfolio so that your diversification works for you and not against your emotions.
So where does this leave us?
As always, it is about framing expectations for me. When looking at the historic relationship between the stock market and U.S. Government Bonds, it is clear that the latter has performed as a hedge against large declines in the former. This relationship, for most of the time period I looked at, was fairly steady. I personally think the last couple episodes in 2000, 2002 and 2008 (Well especially 2008 thanks to the Federal Reserve QE program) were mostly outliers and I expect that in future market declines, U.S. Government Bonds will act as a more subdued hedge, much more in-line with the pre-2000 data points. And you know what? I still think this makes them worthwhile as a diversifying asset in portfolios. Investors just need to understand that the big returns will most likely come back down to earth, but the safety function of these assets should remain intact.
This is similar to a point I touched on at the end of my inflation piece: future returns over the next decade or two could be lower than the prior couple decades, for both stocks and bonds, but that lower inflation could accompany this so that the end result will not feel as “bad” for us. That is my expectation but it is just a guess, not a certainty. My portfolio does not hold a large allocation to bonds. It holds a small amount of bonds because my investment plan says to based on my goals and risk tolerance, not because of this research and my subsequent guess at the future.
In the face of this data, the only other small tip I would offer is to be weary of using historic returns of the last 3-4 decades when making financial planning decisions. In order to reach the goals we have set, we all may have to face the decision between saving more, lowering our expectations or increasing the risk we take in our investment portfolios. Find out which path is most comfortable for you.
Have some fun out there!