Bond Sense

Bonds are on the minds of a lot of people these days. We hear the touts in the financial media tell us: “Sell bonds now! Interest rates are going up! We are in a bond bubble!”. Unfortunately, people who meet with us (our clients and others seeking our advice) voice these same concerns. And why not? The financial media is usually their only source of financial “education”.

Before we get sucked into this hysteria, let’s look at total bond returns during a 20 year period in U.S. history when both interest rates and inflation rose and fell significantly. The period chosen is 1976-1995. During this period the interest rate on 5 year treasuries rose from 7.2% to 14.3% then declined to 6.4%. The annual total return on the Barclays US Aggregate Bond Index varied from 32.6% (1982) to negative 2.9% (1994). Certainly when you look at real rates of return, annual total return minus inflation (CPI), rising interest rates and rising inflation may be associated with low or negative real total bond returns. On the other hand, falling interest rates and inflation may be associated with higher real bond returns. The problem is that the touts and everyday investors want to act on where they think interest rates are heading to make the short-term tactical decision on whether to hold bonds in their portfolio. Let’s look at the data (see chart below) to see if there is any reliable year over year predictive value. 

Starting in 1976, both interest rates and inflation rose significantly. Although the nominal total return (change in bond price plus dividends) was never negative, the real rate of return certainly was. This was a time of high inflation in the U.S. People were bailing out of both stocks and bonds and keeping their money in bank accounts and money market funds (MMF). People who put their money in MMFs in 1976 looked pretty smart in 1980. Looking at the 1980 to 1981 period an interesting thing starts to happen. Interest rates rise from 11.5% to 14.3%. Bond returns should fall right? Wrong! The nominal total return rose from 2.7% in 1980 to 6.3% in 1981! Was anyone telling you to move your money from a MMF in 1981 into bonds? Not likely. We now go from 1981 to 1982. Interest rates fell from 14.3% to 13.0%. How many were predicting that? The common meme was another “end of the world as we know it”. What happened to bond returns? They went from 6.3% to 32.6%! How many touts and investors saw that coming and acted on it? Very few. 

One final example. In both 1988 and 1989 the interest rate held steady at 8.5% and inflation barely changed from 4.4% to 4.6%. What happened to bond returns? They went from 7.9% to 14.5%. How can that happen? Interest rates and inflation were virtually the same for both years. Academic evidence has shown that bond returns are driven by all information available, not only by interest rate movements or inflation. Accurately predicting what that information is in advance in order to act on it is speculation, not investing. That is why decades of compelling research has shown that accurate market predictions are overwhelmingly random events (stopped clocks are right twice a day) rather than prescient insight. 

So what to make of this? The wise investor realizes that speculation is a fool’s errand and creates a financial plan to meet her unique needs and goals. She ignores the financial media (except to laugh at their nonsense). She builds a well diversified all-weather portfolio holding both stocks and bonds, matched to her risk tolerance and long-term goals.

Don McDonaldComment