“One thing I definitely don’t want in my portfolio is bonds,” a prospective client told me a few weeks ago. “Bonds are boring and don’t give good returns.”
Her confidence in her money script that bonds had no place in her portfolio was palpable. However, her understanding of the role bonds play in a portfolio was incomplete. I restrained myself from launching into a lecture on the importance of bonds and simply replied, “While it is true bonds can be boring, sometimes they can be phenomenally exciting.”
Certainly stocks, commodities, and real estate investments are generally much more exciting. They are many times more volatile than bonds; in just a year it’s possible they might even gain or decline 50% in value. Meanwhile, individually held bonds and their mutual funds can crank out predictable coupon yields quarter after quarter after quarter, with one-third of the volatility of stocks. The cost of the lower volatility is that the long-term returns on bonds tend to be half to a third that of stocks.
However, the bond market right now is anything but boring. So far this year, while stocks are back to prices roughly where they were in early 2018, a sharp fall in interest rates has caused bond investors to reap some significant capital gains. Bonds have an inverse relationship with interest rates. The value of most bonds increases when interest rates decline and go down when interest rates rise.
How significant are the gains in bonds? Since the beginning of 2019, investors in the 30-year Treasury bond have seen gains (interest plus price appreciation) of 26.4%. That would be an outstanding full year’s return for stocks. According to the Bloomberg Barclay’s U.S. Aggregate Bond Index, long-term bonds overall have generated a 23.5% return. Investment grade corporate bonds have returned 14.1%, while the 10-year Treasury note has gained 12.6%.
Market observers have predicted for the last decade or so that bond rates have nowhere to go but up. What we’re seeing currently is a yield on the ten-year Treasury note of just under 1.47%. At the end of 2018 it was more than 3%.
Will we see more of the same? It’s very hard to imagine that same 10-year Treasury falling another 1.5%—to zero yield. So the smart money says that most of the gains have already been taken, and anybody looking for 20-plus percent returns in long bonds going forward is just chasing them after the fact when returns are dropping.
But how smart is smart? Just in case you agree and think interest rates have nowhere to go but up, consider that many countries in Europe actually have negative interest rates, where the investor or depositor pays to loan their money to organizations or banks. Another 1.5% fall to 0% interest rates could deliver similar 20% bond returns.
The lesson here is that even if you think of bonds as the boring part of your portfolio, there are times when they can add a little more kick to your returns than you might have expected. And in times of falling equity markets, they are an invaluable buffer against big losses. Still, with the long term probability that bonds produce a return half that of equities, there is a significant chance that they won’t sustain the 20-plus percent returns as rates stabilize and increase at some point in the future.
Unlike the misinformed prospect I visited with, most investors over the age of 40 can benefit by having a substantial slice of their investment portfolio in bonds. Whether their returns are typically boring or occasionally exciting, bonds are an important asset class for diversified investors.