It has become a consistent theme of our letters in recent years to address the disparity in performance between growth stocks (particularly, U.S. large-cap technology stocks) and value stocks (particularly foreign value). This decade-long trend has continued through the pandemic, with sporadic signs of value stocks coming back into favor, only to see growth stocks quickly regain their position. While we continue to believe that these preferences are cyclical, and that the pattern cannot continue forever (though it’s hard to know when it will end), in this letter we’d like to instead focus on a portfolio segment where the consequences of the current market environment seem more clear: longer-term bonds. Simply put, conditions are such that high-quality bonds may not earn investors a sufficient return in the coming years.
40-year bull market for bonds. The 10-Year Treasury yield serves as a good proxy for the state of the bond market (influencing mortgage rates, among other things), as well as a measurement of investor confidence—when yields are low, typically so is investor confidence. It is hard to imagine now, but in 1981 the yield on the 10-Year U.S. Treasury peaked at 15.7%. Since then, the yield on the 10-Year Treasury has steadily declined, hitting a record low in August of this year of 0.6% (see Figure 1). Because bond yields and bond prices are inversely related (high demand for bonds pushes prices higher and yields lower), bond investors have enjoyed a remarkable bull market during that time (see Figure 2) with the Bloomberg Barclays U.S. Treasury: Long Index (which includes U.S. Treasuries with 10 years or more to maturity) generating an annualized return of 9.6% over 40 years through September 30, 2020. For context, the MSCI World Index and the S&P 500 Index had annualized returns of 9.2% and 11.4% over the same period.
With yields falling sharply during the COVID-19 crisis, the Bloomberg Barclays U.S. Treasury: Long Index has returned a surprising 21.4% year-to-date through September 30, outperforming the S&P 500 Growth Index (20.6%) and nearly keeping pace with the technology-focused NASDAQ Index (25.3%). Could such remarkable performance continue? We do not believe it is likely for the reasons discussed below.
Rising interest rates and the risk to bonds. To start, let us examine how purchasers of bonds seek a return on their investment. Bond investors earn money in two ways: through the yield they receive on the bond (income) or through an increase in the bond price (appreciation). A bond’s yield can be thought of as the compensation investors earn for the risk that bond prices will fall due to rising interest rates. The higher the yield, the more compensation investors receive for taking on interest rate risk. Duration is a tool for measuring this risk by quantifying the sensitivity of a bond to changes in interest rates—the longer the bond duration, the more impact rising rates will have on the bond price. In the current environment, government bond yields are at all-time lows while duration has increased, meaning that bond investors are taking on much more risk for much less return (see Figure 3).
Of course, the flipside is that taking more risk typically means that a big pay-off is a possibility, and longer duration bonds would benefit more from falling rates. For U.S. Treasuries, it is certainly possible that yields could fall even further—much of the developed world offers negative yields for their government bonds (for example, the yield on a German 10-year bond was -0.63% as of November 3). However, after the Federal Reserve lowered the Fed funds rate to nearly zero in March, Fed Chairman Jerome Powell explicitly stated he does not view negative rates as “an appropriate policy response here in the United States.” Thus, any potential for positive returns as a result of yields dropping even more would be modest—there just isn’t much more room to fall. And in fact, the U.S. yield curve has been somewhat steepening of late (see Figure 4) driven by optimism for a post-COVID economic recovery and by a Federal Reserve that has pledged to keep shorter-term rates near zero through at least 2023.
The potential impacts of coming inflation. The current outlook for rising bond prices appears to be quite bleak; but, if longer-term yields are likely to rise, does buying bonds for their income hold some promise? Unfortunately, the answer is likely “no” as rising, but still low, bond yields are likely to be outpaced by rising inflation, thus earning bond investors a negative real return. In other words, if a bond is earning a 1% yield and annual inflation is 2%, an investor who bought at par and holds the bond to maturity would be losing 1% in real value.
The massive monetary and fiscal stimulus injected into the economy in reaction to the COVID-19 crisis has raised the prospect of future inflation. The scale of the stimulus is unprecedented. For comparison, during the Global Financial Crisis (GFC) of 2008, Congress passed a nearly $1 trillion bill mostly aimed at shoring up a financial system over-levered and in danger of collapsing. However, the 2020 economic crisis was not caused by excess risk or financial hubris, and the $2.3 trillion in stimulus funds (financed by debt) mostly flowed directly into the pockets of businesses and individuals. As a result, the M1 money supply (which measures the most liquid portions of the money supply, including paper currency and checking accounts) shot up in 2020 by nearly 40% (see Figure 5). This tremendous build-up of liquidity will have to come out into the market in some form. With the current 10-year Treasury yielding approximately 0.80% and the annual inflation rate at 1.4% as of September, the prospect of rising inflation and modest yields is not an attractive combination for bond holders.
What are some alternatives to bonds in a low yield, low return environment? Despite the doom and gloom, there is still a place for bonds in a diversified portfolio. A modest allocation to shorter duration bonds can serve as a stable pool of assets for spending needs, shielding critical funds from the potential volatility of the stock market. However, as a return-generating asset, and as a protection against inflation, investors should look for alternatives to longer-term bonds.
One such alternative is real assets, including commodities such as gold, real estate, and infrastructure. In the case of gold, the value tends to rise in inflationary environments because it takes more dollars to purchase the same amount of gold. Real estate also offers inflation protection, not only because rising prices raise the value of property, but inflation also raises rents and thus increases cash flow. The income generation from real estate investments can serve as a higher-yielding source of income than low-yielding bonds. Similarly, infrastructure investing has inflation-hedging qualities as well. Infrastructure assets are often linked to inflation through long-term contracts or regulation. For example, toll roads may increase fees annually through concession agreements. Utilities are often highly regulated, with arrangements in place (such as regulated pricing or profit margin) to adjust for rising inflation. Additionally, the long-term contracts associated with some infrastructure assets can be a source of stable cash income.
Finally, high-quality, dividend-paying stocks can offer much higher yields than bonds (providing income) while also having the potential for price appreciation. We believe this to be especially true in today’s market environment where value stocks are priced at historical bargains compared to growth stocks, which pay little to no dividend (yes, we couldn’t resist touching on our recurring theme!).
2021 Client Conference Update. Our 2019 Mangham Client Conference was a great success. Given the uncertainty surrounding COVID-19 and to be mindful of everyone’s safety, we plan to hold next year’s Mangham Client Conference virtually through one or more interactive webcasts. Like in previous years, we plan to feature some popular segments such as investment manager interviews by Mangham staff and topical educational sessions. We look forward to sharing more details with you soon. Stay tuned!
As always, we hope you remain healthy and safe. We would love to hear from you and welcome conversation—please reach out to us anytime you would like to chat.
The Mangham Associates Team
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