Think about long-term returns
While we have discussed the short term, more tactical, implications of higher bond yields, we don’t want to lose sight of something very significant that has happened: Bonds have become, after a decade or two in the doldrums, a viable asset class again.
Over the long term, a bond’s yield is generally the most significant portion of its future total returns. As yields have fallen since the 1990s, so have the returns of the benchmark Bloomberg U.S. Aggregate Bond Index, from an average annual return near 7.7% in the 90s, to 6.6% in the 2000s, to just 3.8% from 2010-20191. And while the percentage of that return which was derived from yields falling (capital appreciation) rose, the bulk of the returns remained dominated by the bond’s yield. Now that rates are back to (roughly) where they were in the 2000-2009 decade, chances are good total returns will look more like they did in that decade than the last decade.
To be fair, the current period of higher yields, owing to the sudden surge in inflation, could prove to be a blip. It could last just the decade that a 10-year bond issued today is good for, and we slip back to the world of the previous decade when many argued that secular tailwinds were leading us to a new world of zero (or negative) interest rates.
Those arguing for “structurally” lower rates had good points: Globalization and especially the full entry of China and other emerging markets into the global economy proved to be a strong deflationary force, especially through cheaper goods. Additionally, the need to pay down debt after the housing bubble and the subsequent global financial crisis, particularly by U.S. consumers, but also in Europe more broadly, added to the deflationary tailwinds. But the winds likely are shifting to structurally higher rates due to deglobalization — driven in part by geopolitics — as well as massive investment into decarbonization, aging demographics, and high public sector deficits.
Finding the balance
With nominal and real bond yields in the ranges they are today, we are back to the investment environment of our youth (or for our younger readers, your parents) when bonds had more symmetrical risk (they could go down, but they could also go up). Treasuries have shifted back to their traditional diversifying role in a mixed-asset portfolio with a negative correlation to equity returns. That’s because rates typically fall with poor economic news, increasing the return potential of bonds. On the other hand, equities typically decline on poor economic news as it has negative implications for earnings. The debate should no longer be about whether bonds have a role to play in a portfolio, but how much, what kind, and for how long?
Furthermore, we expect the persistence of higher yields will allow the diversity that stocks and bonds can offer to persist for some time. We believe this is great news for two reasons. First, it means investors who build and maintain diverse portfolios are more likely to have lower volatility, higher income, or both. As a reminder, while diversification can help reduce market risk, it does not eliminate it. Diversification does not assure a profit or protect against loss in a declining market. Second, lower volatility may allow investors to be more confident their net worth will survive whatever the world throws at it.
This is more valuable than you might think. A 2021 Bank of America study showed that panicking is more damaging to your portfolio’s health, while patience more beneficial than most of us imagined. If you invested in the S&P 500 Index in 1930, and stayed invested through 2020, you would have made a 17,715% return. But if you were out of the market for the 10 strongest days in each decade your total return would be just 28%. It pays to be invested, and to stay invested.
And to stay invested, we understand you need to have confidence in your portfolio. To get there, we encourage investors to start taking a more proactive role in their bond investing. It may still be early to shift into second or even third gear, but if you are still in park, we think it’s time to get moving.