Are Bonds a Dangerous Investment? –Revisited

The majority of this article was first featured in our November 2013 release, when, like now, many investors were very concerned about the affect central bank rate hikes might have on the return of bonds and bond-like investments. Since this investment theme has once again become cause célèbre, we thought it was time to revisit the subject. A wonderful thing about history is that its examples are not any less relevant, despite the passage of time.

A Twitter-Worthy Executive Summary

Bond valuations usually suffer from rising-rates, but all bond categories have always been positive in time periods longer than three years.

Historically, the Worst Case Scenario is a Three-Year Delay

Many people are once again becoming worried about bond related assets due to the talking heads in the mainstream media discussing how we are entering a rising rate environment, which is expected to be terrible for bond investments that are thought to suffer during such times. Before we all panic and sell out of our bond holdings, let’s consider the historical perspective. In the time period between October 31, 1941 and August 31, 1981 (the last long-term rising rate time period) the country went through an approximate 40 years of rising rates that took the five year treasury yield from 0.51% to 16.36% (a 15.85% jump overall!). The immediate assumption most would have about this time frame is that bonds would be a losing investment. However, if you take the total return (including the reinvested yield payments) of that entire timeframe, the outcome is actually a positive 3.3% annualized growth rate. This shows that rising rates aren’t necessarily bad for bonds over the longer term, though perhaps future return expectations should be lowered. The worst bond market drawdown (value loss) in that time frame was -8.89% (again including yield payments), which took about eight months to occur and only two months to recoup all of the losses. The chart below shows how a $10,000 investment in five year treasuries would have turned into almost $40,000 over that supposed “bad for bonds” period of time.

_{Source: Rising Rates: The Reality and What to Do. (October 2013). American Century.}

The next table shows various hypothetical outcomes for the broader Barclays Aggregate Bond Index if rates rose between 0-10% from a yield of 2.3% (Note: the current yield as of 7-17-2017 is 2.4%, which shows yields have barely budged in the last 4-years). By year five, most scenarios are positive, and even the worst case is positive by year seven on a total return basis (which includes reinvestment of yield payments received). This shows the real risks posed by interest rates to bond investors is short term in nature and more related to opportunity cost (the cost of giving up a potentially better investment elsewhere) than anything else. For the record, “the largest historic increase in rates in any given 12-month period was 4.51% for the year ended July 31, 1982,”1 which shows there is very little risk of the most extreme 10% interest rate rise actually occurring (since it hasn’t even come close in history) in the short term. Even if rates did rise 10% in over seven years or more, the data projects it wouldn’t be a negative outcome because reinvested yield payments would be constantly buying new higher yielding debt for the investor. The sharp 4.51% rise also occurred during a market environment that was very different from where we are currently, in that the Fed was raising rates quickly to actively fight inflationary pressures of that time. Inflation is almost a non-existent force at the moment. A sharp rise in rates is highly unlikely in the current environment, though the Federal Reserve has made a few small rate hikes over the past year.

_{Source: Roth, A. (November 14, 2013). Bond Worries? What Advisors Should Do. FinancialPlanning.com.}

Projections are good for discussion of “potential” future outcomes, but let’s take a look at actual historic references again. Looking at the real history of five year treasury in the next table we can see that on a total return basis there have been no periods over three years where value has been lost since 1925. This even includes the steep rising rate environment of the late 70s early 80s.

_{Source: Rising Rates: The Reality and What to Do. (October 2013). American Century.}

Looking at the broader Barclay’s Aggregate Bond Index we can see a similar outcome. On a total return basis there have also been no periods over three years where value has been lost since 1976.

_{Source: Rising Rates: The Reality and What to Do. (October 2013). American Century.}

The bond types described above are widely considered to be relatively safe investments. The riskier bonds have had more adverse historic drawdowns (value loss) of course. But even they have recovered there losses with 17 months (approximately 1.42 year) from the bottom in the most extreme example. The below table displays some pretty steep losses, but it also shows that these losses were quickly recouped if investors maintained discipline by not panicking and selling at the market lows and reinvested yield payments received. In most cases the timeframe was significantly less than a year from the bottom and once again there were no periods over three years that saw a negative outcome if yield payments were reinvested.

_{Source: American Century, Rising Rates: The Reality and What to Do}

The important piece of criteria that makes all the different bond assets positive performers over the longer term is the reinvestment of yield payments at increasingly higher interest levels as rates rise. This allows investors to capture the higher income payouts that enable them to become whole for the losses accrued during the earlier part of the rising rate environments. If an investor was drawing on the income or making principal withdrawals from the account for other purposes, then it could be expected that the outcomes would not be so rosy.

The Current CWM PTS® Indication

We perceive relatively little risk from rising rates in the current environment and very high stock market valuations would seem supportive of higher valuations for more conservative investable assets. Our own CWM Performance Targeting System (PTS®) metric stands at 2.08 as of 7/14/17. This is a large jump from last quarters reading of 1.13 and scores above 2 can be said to reflect a market of extremely high valuations. This does not guarantee a market sell-off or crash is near, only that risks are now elevated for markets. At this level we can be highly confident that stocks are more likely to underperform bonds/non-correlated investable assets over the next couple of years, though nothing is ever guaranteed of course. As it stands, the current 2.08 indication suggests we should remain overweight to bonds/non-correlated assets versus stock investments.

Though there is potential for stocks to move higher still, current valuations reflect a high and rising probability of a negative outcome, a risk we are striving to mitigate for our clients. CWM PTS® models continue to be invested conservatively, as they have been for some time. Your CWM team will continue to be disciplined in our efforts to provide the best risk adjusted returns possible.

Please pass this article on to any one you know who may be interested in or might benefit from the information. We are always looking for more great clients just like you and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me at MorganA@CWMnw.com or if you are interested in more regular financial tidbits, follow me on Twitter.

Morgan Arford
Chief Investment Officer, Principal

Reference:
¹ Roth, A. (November 14, 2013). Bond Worries? What Advisors Should Do. FinancialPlanning.com.