Don’t Bank on the Safety of Bonds in a Pandemic

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Today’s market environment requires that we talk candidly about bonds. While investors over the years have turned to bonds for safety, unfortunately they’ve never been riskier than they are right now.

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Over long periods of time, bonds have generated lower returns and lower risk than equities. Bonds also had low correlation with equities, which generates diversification return. Generally, bonds are thought of as safe. Over the last 50 or so years, the 10-year U.S. government bond has produced average annual returns of around 7%.

Ah, the good old days. If you purchased a 10-year U.S. government bond on Oct. 1, 2020, the bond would have yielded 0.68%. In other words, over the next 10 years you would expect to get an average annual return of 0.68%. That’s about 90% less than the average returns over the past 50 years. It’s also pretty close to zero.

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At the beginning of this year, the U.S. bond yielded 1.88%. Year to date those same bonds have delivered total returns of around 7%. How? Well, the yield went down from 1.88% to 0.68%. When the yield goes down, the price of the bond goes up, and vice versa: When rates rise, bonds fall in price.

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So, the yield is 0.68%. If you buy a bond for $100, and you get a 0.68% return for a year, you then will have $100.68. But did you really make money? There is a concept called “real return,” which takes the effect of inflation into account. If inflation were zero, then yes, you made 68 cents. But what if inflation were 1.8%, as it was in 2019? Well, the $100 would only be worth $98.88. You would have lost purchasing power.

Where do we stand today, not only with nominal rates, but real rates? Certainly negative! Below is the yield on the 10-year bond since 2018, as well as the real rate of return. The orange line indicates the real rates bond holders have been seeing, and the dark red line delineates between positive and negative returns.

Graphic shows real rates of return on 10-year bonds are currently negative

So, an owner of a U.S. government bond can expect to lose purchasing power. And the nominal yield of 0.68% is near the lowest on record. If rates and inflation stay where they are, U.S. bonds are likely to be a poor investment. If inflation rears its head within a decade, they are likely to be very harmful to our purchasing power. The same remains true if rates rise over the decade. Low upside, large downside. It seems that bonds have never in history been as risky as they are today.

We say, “No thanks.”

What to Do? In the Face of Uncertainty, Diversify

If you asked me a few years ago whether we would have all-time-low nominal rates, negative real rates, along with exploding government debt, I would have thought it unlikely. That scenario never happened before, and it is tough to figure out why investors would accept those conditions rather than move their wealth into other assets. Plain, old U.S. government bonds are unappealing (another word for “risky”). Since yields on developed international bonds are no better, international bonds, when denominated in U.S. dollars, are unappealing as well.

If we are unlikely to make money from owning plain old U.S. government bonds, what can we do? Diversify. If we buy international bonds (with comparably low yields) denominated in international currencies, and if the value of the dollar drops, these bonds may rise. The same goes for emerging market bonds, which have the added benefit of higher yields. How about inflation-adjusted bonds? If inflation rises, these bonds may do well. Floating rate bonds may benefit if rates rise. The time for a plain old U.S. bond portfolio is gone (not that we had one of those portfolios before). When I discuss bonds with colleagues in the industry, the prevailing answer is “we are just holding our nose and keeping the same portfolio as before.” I find that unacceptable.

As such, the composition of your bond portfolio should be changing just as dramatically as yields have changed. All of these sources of diversification should be considered. Changing times require a new game plan.

Underweight traditional U.S. government bonds.
Overweight inflation-protected bonds like TIP for U.S. bonds and WIP for international bonds. Floating rate bonds like USFR. International currency bonds like BWX for developed markets and EMLC for emerging markets.
Take a higher cash position. At least cash won’t lose value if rates rise.

Why You Shouldn’t Reach for Yield

To paraphrase Warren Buffett, we have to run the conservative side of the portfolio so that every check clears under any circumstance. Thus, you might want to consider only owning government bonds (both U.S. and international) in the bond section of your portfolio. What about corporate bonds or high-yield bonds or municipal bonds? The value of a bond is directly tied to its safety. In times of stress, safety — or lack thereof — is revealed. The chart below shows the performance of different types of bonds during the most recent time of stress, March 2020.

Graphic shows U.S. government bonds have been more stable than municipal, corporate or high-yield bonds

During just this three-week period, when people were most worried about the value of their investments, municipal bonds lost 13%, high-yield bonds lost 19%, and corporate bonds lost 20%. Granted, they have recovered most of their losses since then. This time around. The next scare … who knows? I recommend sticking with government bonds of various varieties.

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Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Randy Kurtz, RIA, CFP®, is a nationally recognized expert on risk. Challenging the financial industry's status quo for over a decade, Kurtz feels the standard Wall Street portfolio comes with far more risk than clients realize. He created a method of investing that aims to lower excess risk taken in client portfolios, without reducing expected return. His goal is to transform the industry by turning the client-adviser relationship from a return-centered conversation to a risk-centered one.