Investors’ love affair with bonds has likely come to an end. The yield on the 10 year U.S. Treasury bond peaked at just under 16% back in 1981. Over the next 35 years, this rate dropped continuously reaching a low of 1.375% in the summer of 2016. This decline fueled perhaps the longest bull market run in U.S. bond history with investors enjoying an 8.4% average annual return over the period.
In addition to providing stellar returns, bonds also acted as an effective hedge against stock price declines during this time. Stocks fell in 6 of those 35 years and, in each of them, bonds produced offsetting gains.
Today many investors are questioning the wisdom of holding bonds. While the rate on the 10-year Treasury has crept up to 3.2% from its 2016 low, it remains at relatively low levels. And twice in the last year, bonds have failed to protect investors by falling rather than rising during periods of stock market declines.
Do bonds still make sense in a portfolio? We think the answer is yes, but let me explain. As a general rule, bond prices move inversely to the general level of interest rates. Stocks, alternatively, tend to move ahead when economic growth and corporate profits are rising. During a recession, stock prices decline along with corporate profits. Interest payments on bonds (particularly higher quality ones) remain fairly stable so bond prices hold up well. If the downturn is severe enough, central banks cut interest rates and, under such conditions, bonds actually increase in value. The reverse is also true. Stocks do well during periods of economic expansion. But accelerating demand for credit and/or Federal Reserve efforts to cool off the expansion tend to cause higher interest rates and falling bond prices. This relationship between stock and bond returns (termed negative correlation) has held up remarkably well over time. As the chart below shows, since 1929 there have been only three years when bonds and stocks declined in tandem.
These three times are worth paying attention to today. Two of them were accompanied by fairly unique events; the collapse of a major European Bank (1931) and the U.S. entry into WWII (1941). But the third in 1969 was triggered by an unexpected increase in inflation and faltering economic growth. The lesson here? Bonds have historically helped cushion risks associated with recession but do not perform well in periods of unanticipated escalating inflation. Inflation that is generally expected isn’t so much of a problem because it is already factored into the prevailing level of interest rates and bond prices.
The relatively low level of interest rates today suggests that future returns could be muted for some time. But after nine years of stock market gains, it is easy to forget the volatility that stocks can impart. Yes, bonds are down 2%-3% so far this year but that is a far cry from the average 30% decline experienced during the 11 bear markets since 1926. So, why hold bonds? Because they are not stocks. In short, they offer a pretty good form of insurance that actually pays you income along the way.