Time to Buy Bonds?
Is it time to buy bonds?
This question has become much more common as interest rates have risen. Recently, the yield on 10-year U.S. Treasury bonds hit 5% for the first time since 2007. Many money market mutual funds (say that five times fast!) are yielding over 5%.
In addition to higher yields, many economists are still forecasting a recession in 2024. Rising geopolitical tensions may give more reason for concern in the short term. And the market currently thinks the Fed is likely to cut rates by at least 0.75% by the end of next year (be careful what you wish for here).
So, are bonds a good buy now? Here are a few considerations before pulling the trigger.
(Scroll to the bottom if you prefer video!)
Income
One of the most obvious implications of higher interest rates is higher interest rates! Investors have the ability to generate more income with greater certainty. Need a 5% pre-tax return? No problem. During the 2010s, when rates in the U.S. were historically low, many investors felt pushed into more volatile investments to earn a reasonable return. Those days, at least for now, are gone.
Yields on the safest bonds (AAA-rated) are around 5.3%, and investors can buy investment-grade bonds (BBB-rated) yielding well over 6%.
Sure, taxes and inflation will take a bite out of these returns, but it seems easy to understand why 5% or better appears attractive for risk-averse savers and investors. In short, generating reliable and stable income from bonds hasn’t been this attractive in years.
Protection & Diversification
We often talk about bonds as a ballast for the portfolio, something that can offset equity volatility in tough times.
When looking at bonds through this lens, it can be important to understand the different types of risks inherent in bonds. Keep in mind, two components drive the total returns from bonds - the income component and the price component, i.e., did the bond go up or down in price.
High quality bonds like U.S. Treasury bonds are sensitive to changes in interest rates. You have probably heard the teeter-totter analogy. When rates rise, the price of bonds fall. And just as the ends of the teeter-totter move much more than the parts closest to the fulcrum, longer-term bonds are much more sensitive to rate changes than short-term bonds. Look no further than 2022. Long-term Treasuries (the 30-year bond index) fell over 30% while short-term (1-3 year index) lost about 4%. Quite the difference. The chart below shows other periods of rising rates, and how different types of investments performed (click to expand).
These high quality bonds have historically provided more protection during recessions, when policy makers react by cutting rates to stimulate economic activity. Investors that believe rates will fall in the future are likely to find longer-term bonds attractive, all else being equal.
Lower quality bonds are typically more sensitive to changes in the economy than changes in rates, and this is commonly referred to as credit risk. Borrowers issuing these bonds may struggle to make interest or principal payments if the economy softens, so these bond prices often move in the same direction as stock prices.
For investors (like us) wanting bonds to act differently than stocks, It’s important to understand which bonds are exposed to which risks. We hope to avoid unwanted surprises. And with interest rates near 15-year highs, high quality bonds seem likely to offer better protection than when starting yields are much lower.
Back to the point of offsetting stock market risk. Owning bonds alongside stocks can lower the volatility of an investor’s portfolio, but only if bond prices move differently than stock prices. That may sound obvious. But it isn’t always the case. Look at the chart below, which shows 2-year correlations between prices of long-term U.S. Treasury bonds and the S&P 500. Green bars indicate periods where stock prices and bond prices had a positive correlation, meaning they had a tendency to move the same direction at the same time. Not exactly what people want, if they are hoping for diversification benefits. Orange bars, on the other hand, meant stocks and bonds had a negative correlation, or they moved in opposite directions.
For most of the last 25 years, bonds and stocks moved in different directions, when the bars were orange and correlations were negative. That relationship changed dramatically over the last couple years, as rising interest rates and inflation punished both stock and bond prices. Green bars indicate stock prices and bond prices moving the same direction. The same was true for most of the 1980s and 1990s. Baby boomers in particular will recall high rates from the 1970s and 1980s, and as rates fell from those peaks, bonds gained alongside stocks.
Interest rates near 5% may seem attractive, and we would expect bonds to be a good diversifier if the economy grows slower than expected in the years ahead. But we think it’s helpful to remember adding other non-correlated assets can be valuable to bring down the overall volatility of an investor’s portfolio.
Returns
Stock returns are notoriously difficult to predict, especially in the short-term. When estimating bond returns, the starting yield has been a decent indicator of what to expect. The chart below shows the starting interest rate on a 10-year U.S. Treasury bond (orange dot) at the beginning of each year since 1973, and the subsequent 10-year annualized total return (green bar).
No, the starting yield isn’t a perfect indicator. But the results have been good enough for us to pay attention. Would a 5% return over the next decade be acceptable? For many investors, it seems the answer would be yes. Especially if we consider financial planning and the assumptions behind those plans. At the end of 2022, many firms were predicting long-term government bond returns around 3.5%. Earning closer to 5% feels like a big win, viewed through this lens.
You may wonder, how do these returns compare to stocks? This is the same chart, with S&P 500 total returns displayed by the black dots.
As you might expect, stocks outperformed most of the time. Having the benefit of waiting a full decade historically tilts the scales toward stocks. They beat bonds during every 10-year period in our example except for these five:
1973-1982
1999-2008
2000-2009
2001-2010
2002-2011
Four of these periods included two of the worst bear markets since the Great Depression, when the tech bubble burst in the early 2000s and during the global financial crisis in 2008.
We often talk about long-term portfolios deserving long-term allocations. If you have a long horizon, your ability to accept short-term volatility from stocks, in theory, should rise. And, for the most part, investors have been rewarded for accepting those short-term stock market ups and downs with higher long-term returns. This data would seem to agree.
Summary
Is it time to buy bonds? Coming off a decade of ultra-low rates, earning 5% without stock market risk can certainly seem like an attractive tradeoff. For many investors, that return may be more than enough to accomplish their goals. Taking advantage of today’s rates by buying longer-term bonds could have a couple benefits. First, steady and reliable income. Second, if rates fall in the future, prices of those bonds should rise. Locking in higher interest rates by buying longer-term bonds, on the margin, might make a lot of sense. Higher rates could also provide a better starting point from a diversification perspective, but we need to make sure we understand if the bonds we own are most sensitive to changes in rates or the economy. Finally, we would encourage investors to revisit their expected time horizon and design their investment strategy accordingly.
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