The Role of Bonds in a Low-Yield World

Should investors try to replace the return on long-term bondsA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. in a low-rate environment? Do bonds still have a role in a diversified portfolio? Chairman Dan Wiener discussed the state of the bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. market in our recent webinar,* Inflation, Inoculation and Infrastructure: Defining the New Normal.

Please enjoy the excerpt below and click here for the full webinar replay to hear more. 

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Dan Wiener:

The bond market has been going up for 40 years. In fact, it hit an all-time high in August of last year. You couldn’t get a 40-year Treasury bond 40 years ago, but someone who bought a 30-year Treasury in 1981 earned more than 13% a year for 30 years. Over that time, interest rates went lower and lower, but they kept earning 13%. By the time that bond matured in 2011, you could only get 4.5%, or about a third of the yieldYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price., on a 30-year bond. That gives you a sense of just how well bonds did for three decades.

By the way, inflation ran 3.1% over that 30-year period. Earning 10% above inflation for 30 years is unheard of. So, falling bond prices are, I think, a brand-new situation for most active investors today.

If you think about someone who begins to invest at age 20, maybe through a 401(k) at work, you’d have to be 60 years old or older today to know what it means to see both a falling bond market and inflation. Since that 30-year bond I talked about matured in 2011, inflation has just run 1.7%. So, even if the person who had sold the 30-year bond 10 years ago, and bought the 4.5% 30-year bond that was available, that yield still looks pretty juicy today given that yieldsYield is a measure of the income on an investment in relation to the price. There are several ways to measure yield. The current yield of a security is the income over the past year (either dividends or coupon payments) divided by the current price. on 30-year bonds today are at about half that level. So, even experienced, older investors like me haven’t seen bond prices do much more than rise for most of our investment education.

So, now what? You have to understand and accept that bonds aren’t going to make lots of money. But they still have an important role in the portfolio. They’re a buffer against volatilityA measure of how large the changes in an asset’s price are. The more volatile an asset, the more likely that its price will experience sharp rises and steep drops over time. The more volatile an asset is, the riskier it is to invest in.. It keeps you in the stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. market, but there’s more to knowing thyself than just accepting the facts about stocksA financial instrument giving the holder a proportion of the ownership and earnings of a company. that haven’t had a big or long bear marketA period in which stock prices decline significantly from recent highs and remain below previous high marks for weeks or months. Generally, a decline of at least 20% in stock prices is considered the threshold marking the start of a bear market. and bonds that simply can’t do what they did for 40 years.

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