Over the past 40 years, there has been a one-way trend in US Treasury Bond Yields: down.
US 10-Year Treasury Yield…
— Charlie Bilello (@charliebilello) September 18, 2020
September 1980: 11.6%
September 1985: 10.4%
September 1990: 8.9%
September 1995: 6.2%
September 2000: 5.9%
September 2005: 4.3%
September 2010: 2.8%
September 2015: 2.2%
September 2020: 0.7%
If you’re a bond investor, that has been a beautiful thing, as bond prices move inversely to interest rates.
And after inflation, investors were highly compensated as well, earning an average real yield of 2.7% over the past 40 years.
But that was the past.
It’s no country for old yields.
Today the 10-Year Treasury yield is at 0.69% and core inflation is at 1.7%, meaning bond investors are not only earning the lowest nominal yields in history, but also a negative yield after adjusting for inflation.
The 40 part of the famed “60/40 portfolio” now has little prospect of long-term reward with significantly higher risk (duration, or a bond’s sensitivity to interest rates, increases as the yield goes down).
And that’s if you go all the way out to 10 years in treasuries. Shorter duration government bonds are essentially yielding nothing (5-Year at 0.27%, 3-Year at 0.16%, 3-Month at 0.10%), and the Fed has promised to keep it that way for years to come.
What is a bond investor to do?
There are no easy answers.
Some may choose to stay within bonds and move up the risk spectrum. What they’ll find there are yields that are also at/near all-time lows.
- Bonds with A rating. These include the largest Bond ETFs that track the broad bond market, from iShares ($AGG) and Vanguard ($BND). Current yield: 1.2%.
- Bonds with BBB rating. Investment grade corporate bonds (Largest ETF being $LQD). Current yield: 2.0%.
- Leveraged Loans (ETF: $BKLN). Below investment grade loans that are senior secured (top of company’s capital structure). Current Yield: 4.0%.
- High Yield (Junk) Bonds (ETF: $HYG). Below investment grade corporate bonds. Current Yield: 4.5%.
Others may choose to move up to hybrid securities like convertible bonds (1.0% yield on $CWB) or preferred stocks (4.5% yield on $PFF), whose yields are (you guessed it) also at all-time lows and whose risk of loss is considerably higher than bonds.
Others still may move to equities, trading short-term security for the hope of higher long-term capital appreciation.
All of these options require investors to increase their tolerance for risk, generally not a good idea in finding a bond substitute. Taking more risk is the easy part; it’s your tolerating it when it comes that’s considerably more difficult.
A final option is to create a barbell strategy where you divide your portfolio into risky securities and cash, with cash serving as buffer that bonds used to represent and dry power for when the risk/reward in bonds or other asset classes improve. Such a strategy, while protecting your portfolio from rising interest rates and/or credit spreads, requires much patience and a tolerance for no yield (and negative real yields) while you wait.
Over the last 40 years, a position in treasury bonds gave investors downside protection (low to negative correlation during bear markets) and a positive real return in their portfolio. Today, only the former is true and that too is questionable (if there is a sell-off in risk assets due to rising rates/inflation, safe bonds will not be the hedge they have been traditionally).
The risk/reward prospects for bonds have changed, and all investors must grapple with how to build a portfolio without old yields.
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