“It’s not that I’m so smart; it’s just that I stay with problems longer.” – Albert Einstein
Bonds could use a public relations makeover.
The traditionally stable asset class is coming off one of the worst years ever.
Investors are asking, “why would I own bonds if they go down with equities?”
It turns out higher inflation and higher interest rates are bad for all asset classes, including bonds.
Looking forward, what are bond returns following a year in which bonds experience losses? To keep it simple, we use a 10-year U.S. Treasury as our bond proxy.
The goal is to examine performance after the 10-year U.S. Treasury posted a calendar year loss (period 1928 – 2022, if returns were negative for consecutive years, we include the next positive year).
*Skip ahead to the summary if you don’t care about the data*
Source: New York University (data set available here)
A few observations from the data set:
• In 94 years (1928 – 2022), the U.S. 10-year posted a negative return 19 times or ~20% of the time.
• Following the 19 instances of a loss, the U.S. 10-year achieved a positive return 16 times or ~84% of the time the next calendar year.
• The U.S. 10-year exhibits positive skew characteristics. In other words, losses tend to be small, while gains tend to be large (there are exceptions, see 2022).
• Back to back negative return years for the U.S. 10-year are rare, occurring three times over the past 94 years or ~3% of the time.
Zooming out, here’s why we think bonds add value in multi-asset class portfolios.
1. Diversification breaking down is an exception rather than a rule. Thus far in 2023, bonds have resumed their traditional relationship with stocks (bonds historically perform well when stocks perform poorly).
2. Borrowing and lending is the oldest form of finance. The practice goes back to Mesopotamia in 2000 BCE where farmers would borrow seeds and animals for repayment later. Despite calls questioning the merit of bonds in diversified portfolios, the practice of borrowing & lending is not going anywhere.
3. An individual bond is a contract. An investor knows what they own i.e. (not obvious in mutual funds), how much interest is earned, when the bond matures, and how much principal is returned.
4. If you are risk-averse or think things will get worse in financial markets, high-quality bonds tend to hold up well during recessions (see “Assets That Could Hold Up During a Recession“).
5. Fixed income finally has income. The last decade of zero interest rates meant high-quality bonds yielded next to nothing. That’s changed (see “Silver Linings in a Dismal Year“).
6. While it’s Impossible to predict future stock returns, empirical evidence would suggest yield-to-maturity is a great proxy for estimating bond returns (for investment-grade bonds held to maturity). In general, higher starting yields can equate to higher future bond returns.
In our opinion, bonds are the most complex and confusing asset in existence. Even savvy professional investors fail to understand the risk/return characteristics of the opaque asset class (look no further than the risk managers at Silicon Valley Bank, which we covered here).
With an eye on quality, managing interest rate risk (duration risk), and proper diversification, we believe bonds are well positioned reduce risk in multi-asset portfolios and (finally) provide some income.
For more information on bond returns, inflation, and rising rates, see “Does it Still Make Sense to Own Bonds?”
To speak to a professional investor about building a proper bond portfolio, click here.