Bonds, Bubbles and Biases

By Charlie Bilello

23 Jan 2020

What returns are you expecting from bonds over the next five years?

If you’re like most investors, your answer is probably too high.


Because of something called recency bias, the human tendency to give more weight to the recent past in making projections about the future.

And why is that a problem today?

Because US Bonds are coming off their best year since 2002, with a total return of 8.7% in 2019.

After such a strong year, it’s only natural to be overly optimistic about future returns, expecting more of the same.

There’s only one problem: the stubborn reality of bond math.

Let me explain.

The single best predictor of future bond returns is their starting yield. The lower the starting yield, the lower the future returns…

Where do we fall on that chart today?

All the way to the right. The current 10-Year Treasury yield of 1.73% is lower than 97% of historical readings dating back to 1976 (inception of the Barclays Aggregate Bond Index).

We should therefore expect future returns to be lower than almost any point in history.

But Charlie, can’t today’s low yields go even lower, driving the price of bonds higher?

Yes, absolutely. In the short run, bond returns can be more influenced by changes in interest rates than by absolute yield levels. We saw that in 2019 as interest rates fell across all durations, driving bond prices higher.

Looking out 1 month, there is only a minor relationship (10% correlation) between starting yields and forward returns. The chart almost seems random, with yields having no predictive power at all.

But over time this relationship slowly begins to shift, as a bond that’s not at risk of default will start making its way back towards par by maturity.

By the 1-year time frame, the correlation between beginning yield and forward return moves up to 63%.

By 3 years, it’s at 83%.

By 5 years, the correlation moves all the way up to 93%, and by 7 years the relationship is nearly 1-to-1 (97% correlation).

Let’s go through an example to illustrate how bond math plays out in real life.

The 10-Year Treasury was yielding 3.03% at the end of 2013. By the end of January 2014, it had fallen to 2.64%, driving bond prices higher and pulling forward returns. The Barclays Aggregate was up 1.48% in that month alone (almost half a year of interest), an annualized return of over 19%. By the end of 2014 the 10-Year Treasury yield had fallen all the way down to 2.17%, with bond prices moving higher in tandem.

As the months and years went by, however, the impact of low yields became increasingly important. The bond investor who started in 2014 would end up earning an annualized return of 2.5% over the next 5 years, in spite of the fact that 10-Year yields fell from 3.03% to 2.69% during this time.

The average 10-Year yield during that period was 2.3%, meaning that older bonds paying interest/principle were reinvested in lower yielding securities. While a decline in interest rates provides a short-term boost to bond prices, over longer periods of time rising interest rates are actually preferable as it allows you to reinvest in securities with higher yields. And as we have outlined, higher yields = higher returns.

Ok, by now you get the point. Investors should be expecting much lower returns from bonds over the next 5-7 years, regardless of the direction of interest rates in the interim.

But a few questions remain: 1) how much lower – what is the worst case scenario? 2) Are bonds in a bubble? 3) What, if anything, can/should you do about it?

Let’s attempt to answer each of these questions…

1) Worst Case Scenario?

The risk in bonds is not nearly the same as the risk in stocks. A bad year in bonds is equivalent to a bad day in stocks. There have been only 3 down years in bonds going back to the inception of the Barclays Aggregate Index in 1976.

The worst of these was a 2.9% loss in 1994 when yields moved from 5.82% to 8.21%.

In terms of historical drawdowns, the worst ever was a 12.7% decline back in 1979-80. 2 months later, the bond index was back at new highs. In more recent years, 3-4% dips have been relatively common.

As your holding period in bonds increases, the risk of loss goes down as bonds at maturity return to par. There’s never been 5-year period in which bonds have declined, with the lowest 5-year annualized return of 1.5% (2013-2018).

2) Are Bonds in a Bubble?

Jamie Dimon seems to think so, judging by his comments this week…

And with negative yields across Europe and Japan, it’s hard to argue with his logic.

But a bubble in bonds is not the same as a bubble in stocks. After its peak in 2000, the Nasdaq would decline over 80%.

A similar decline in government bonds without default risk is impossible. Yes, if interest rates go up, bonds will suffer short-term losses. And with yields so low today it wouldn’t take much of a rise in interest rates for those losses to exceed anything we’ve seen in the past few decades.

But as we covered earlier, those losses will be temporary, as bonds will start moving back to par over time. The real bubble to be worried about in bonds is one of expectations, where investors still seem to be expecting the high returns of the past despite the math that argues against it.

3) What, if anything, can/should they do about it?

So if bonds are higher risk and lower reward instruments today, why hold them at all? Good question.

If stocks never went down, there would be no reason to. But alas, they do down at times, and when they do, it can be helpful to offset the declines with an asset class that has no correlation to stocks.

Since 1977, the S&P 500 has had 8 down years. In each of these years, bonds finished higher.

A position in bonds allows investors to better withstand equity declines and to hopefully rebalance into equities at lower prices and valuations. For investors close to retirement or in the early withdrawal stages, bonds play a more critical role as tolerance for a near-term drawdown is significantly lower.

But what about the fact that bond returns are likely to be lower going forward? Should investors simply accept that fact or do something about?

There are 3 options here:

(1) Take more risk by shifting to higher yielding bonds (increase duration or credit risk).

(2) Take more risk by shifting to equities.

(3) Earn more, spend less, retire later.

The first two options would require investors to increase their tolerance for risk, generally not a good idea. Taking more risk is the easy part; it’s your tolerance that’s hard to change. You establish a set tolerance because it’s what you can withstand when things go south and still maintain your position.

Increasing your risk above that tolerance puts all that in jeopardy. Many investors who took too much risk heading into 2008 would eventually sell and go to cash, missing out on the subsequent rebound and a decade of compounding. More than anything else, the goal for investors should be to remain invested, and to do that you must find a portfolio that allows you to sleep well at night.

Even if you were able to increase your risk and tolerate it, there’s no guarantee that the returns for riskier bonds and stocks won’t be lower in the near future as well.

With high yield bonds near their lowest yields ever and equity valuations at the higher end of the spectrum, that very well could be the case.

12-Month Yield for largest High Yield Bond ETF (HYG)

Which leaves us with the last option: earning more, spending less (saving more), and retiring later.

None of these are easy, but they are at least possible and often within your control (at the very least, the spending part). The same cannot be said for squeezing a higher return out of the bond market.

Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.

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