by Matt Malick and Ben Atwater
For the last thirty years, bond yields have fallen fairly consistently. Consequently, bond prices have risen over this period of time. It is often said that “what goes up must come down,” and this is probably the case with bond prices. In an environment where the Federal Reserve has lowered short-term interest rates to zero and engaged in active bond buying (quantitative easing) to push down long-term rates, is the party over for bond holders? Are we about to enter a new super-cycle of rising interest rates that will leave bond investors licking their wounds?
It is interesting to note how stocks and bonds performed during prior super-cycles of rising and falling interest rates.
From 1982, after interest rates peaked, through 2012, the Barclays Capital Aggregate Bond Index returned an average of 8.82% per year. Stocks also did well during this period, with the S&P 500 returning 11.14% per year, but with far more drama, especially from 2000 until now. Therefore, purely from a “sleep at night” perspective, owning bonds for the last thirty years served investors well, even though stocks actually did better.
According to Craig L. Israelsen, an associate professor at Brigham Young University, the federal discount rate (which the Federal Reserve sets) was 1.34% in 1948, similar to today. Over the next thirty-three years, this rate climbed somewhat steadily to 13.42% in 1981- reflective of a prolonged and dramatic increase in interest rates. During this time, the Barclays Capital Aggregate Bond Index provided an average annual return of only 3.83%. Meanwhile, the S&P 500 returned 11% annually during this period of rising rates.
In other words, stocks did well during a prolonged period of rising rates (1948 – 1981) and falling rates (1982 – 2012). Bonds, however, delivered significantly lower returns when interest rates were on the rise.
Using a slightly different time period when interest rates increased dramatically, 1941 to 2009, Fidelity Investments calculated a 3.3% per year return for Treasury bonds. However, after backing out an average annual inflation rate of 4.6% over the period, the real return for Treasury bonds was -1.3% per year.
This does not mean, however, that bonds should be irrelevant to investors. The chart below shows that even in a rising rate environment (1941 to 1981), bonds lowered overall portfolio volatility (standard deviation). A 100% stock portfolio from 1941 to 1981 returned 11% with a standard deviation of 14%. Adding just 20% to bonds reduced overall return by about 9%, but volatility dropped by more than 20%.
Given the present depressed level of interest rates, we can infer three things from the last 70 years of history: 1) Bonds should experience below average returns and probably will not outpace inflation over the next several decades, 2) Bonds still have a place in the portfolios of risk-averse investors as a hedge against volatility and 3) Stocks will likely dramatically outperform bonds over the long-term.
