As originally published by Forbes.
Many believe that bonds, especially US government bonds, are a poor investment right now, but there are many reasons to think otherwise.
While my company doesn’t actively bet on the bond market, or any market for that matter, bonds are part of our long-term asset allocation, and it’s going to stay that way.
Some history might be helpful: In September 1981, the US 10-Year Treasury Bond yielded 15.8 percent. That was the same year Mohammad Ali retired from boxing, the Sinclair ZX80 was state-of-the-art computing, and American Airlines introduced us all to the idea of frequent flyer miles.
Since then, bonds yields have followed a downward trend to their current level of about 2.6 percent, nearly a sixth of what they once were. The decline in yields has followed a decline in inflation, which central bankers sought to limit after the crises of the 1970s. While there are many other historical nuances, falling inflation was a leitmotif not just in the US, but globally.
When a bond’s yield declines, its price rises (bond yield and price having an inverse relationship), so over the past 33 years, the 10-year Treasury bond has increased to six times its initial price as yields have dropped. That price increase comes before any interest payments. Together, that’s an impressive return, but the great bull run in Treasuries is often ignored. This is due to the efforts of its attention-grabbing sibling: the S&P 500. Since 1981, the S&P 500 has increased to more than 15 times its initial price, and that’s before payment of dividends.
The case for equity is clear, but it’s worth remembering just how much bonds have helped portfolios historically, before kicking them out of your portfolio.
Bonds returns are non-linear as you step down the yield curve. That means the relation between yield and price is not one to one. While the math isn’t riveting, it can be surprising, and it’s important to understand.
If yields rebound 1 percent from their low, 10-year Treasury prices will fall 28 percent. But if yields fall another 1 percent, 10-year Treasury prices will rise by a whopping 63 percent.
Each concomitant decline in bond yields, as those yields approach zero, has a disproportionate effect on bond prices, which go through the roof in such scenarios. And if you think the idea of yields falling below current levels to something like 0.6 percent seems crazy, then you should look east.
If there’s one country that proves US Treasuries do not necessarily have to rise, it’s Japan.
Yields on the Japanese 10-year government bond are 0.6 percent. That may seem like a small step from US levels, but falling that far would send the price of the US Treasury up by 4.5 times.
Of course, Japan has experienced deflation, and a policy reaction to it, which helps lower bond yields. The US also flirted briefly with deflation in 2009, and though US inflation is now at 2.6 percent, it is once again declining.
Interestingly, Japan’s current inflation of 1.6 percent is close to the current US level. The potential for deflation could drive US yields lower, particularly in an economy where growth unexpectedly stalled in Q1 of this year. While there are marked differences between Japan and the US, above all the more favorable US demographic trends, the two modern, developed economies aren’t all that different.
Even if the US doesn’t follow Japan, Europe could exert further downward pressure on global bond yields as central bankers across the pond start to follow some of the US playbook. The yield on the German 10-year government bond is now 1.2%, significantly below US levels. Government 10-year yields in France, the Netherlands and Switzerland are also lower than in the US.
Trying to learn from Japan, the Federal Reserve would like bond yields to rise, as that would imply higher inflation. Federal Reserve Chair Janet Yellen has said she’d like to see interest rates closer to 4 percent. But statements like that risk confusing policy targets, side effects and probable outcomes.
Central bankers’ announcements try to steer the economy as much as forecast it. That is, just because the Federal Reserve would prefer higher yields doesn’t mean they will come about. While the Fed’s current assessment of the economy is insightful and comprehensive, their longer-term predictions contain a modicum of self-interest regarding policy.
Stepping away from policy for a moment, we shouldn’t ignore how stocks play into this debate. No asset class exists in isolation, and bonds can be a great hedge against an equity position. When stocks are favored, as they have been recently, bonds get a bad rap, and vice versa. Stock market declines are often paired with stable-to-rising bond prices.
The S&P 500 rose 30 percent last year, its best annual performance since 2007, so it’s probably worth examining whether stocks are trading at relatively high or low values, compared to companies’ earnings.
When gauging the price-to-earnings ratio, it’s best to compare stock prices to their 10-year average of earnings in order to factor out the business cycle. By that calculation, stocks are trading at almost 20 times earnings, while the historical average is 15.5 times. While stocks may not be expensive, they’re not cheap by historical standards.
This does not mean stocks will fall any time soon (short-term stock market declines are one of the hardest things to predict), but that ratio is a relatively reliable indicator for performance of stocks over the next ten years. As such, is interesting to note that both stocks and bonds appear to be expensive compared to their historic valuations. If the stock market falls, bondholders are the likely beneficiaries.
The sell case on bonds becomes much weaker if every sale involves a corresponding stock purchase, since switching money to stocks at current levels doesn’t necessarily make sense in the context of stock valuations that could also be considered expensive.
Of course, there are many alternative markets, but stocks and bonds are considered the most fundamental building blocks of portfolios and the most common substitutes for each other. In addition, by selling bonds, you’d be giving up the diversification effect that makes stocks and bonds such useful partners in a long-term portfolio.
Some argue for switching from bonds to high-yielding stocks right now, and though there’s a lot to be said for dividend-paying stocks over the long term, they’re not substitutes for bonds in portfolio construction, since their correlation with stocks is dramatically higher.
We don’t have an active forecast on the markets, but we believe the sell case on bonds seems overdone.
To recap: Bonds continue to be a useful instrument. Stocks have become expensive in a way similar to bonds, but their valuation has received less attention. Japan’s recent economic past, Europe’s economic present and America’s rough passage in 2009 suggests that deflation is something we cannot discount.
If deflation happens, we should brace for lower bond yields and higher bond prices. America’s declining labor force participation and the pause we saw in Q1 in the US suggest we may not get back to normal as soon as we’d like.
The views expressed represent the opinion of the author and are not intended to serve as a forecast, a guarantee of future results, investment recommendations or an offer to buy or sell securities from FutureAdvisor.