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Rekenthaler Report

Four Questions About Bonds

How to invest when yields on high-quality bonds disappear?

Common Concerns
This week, I saw a note from one of the world’s largest asset managers. The company is attempting to compile answers to common queries about bond investing that it now receives, both from individual and institutional investors. This column posts and addresses that note’s major questions, on the presumption that some of these thoughts may also have crossed your mind. (They certainly had crossed mine.)

Balanced Portfolios
Should bonds continue to be a part of the traditional 60/40 balanced portfolio, given their low yields and presumably low future returns?

That phrasing understates the matter. Ten-year Treasuries now yield 0.70%. With the 10-year breakeven inflation rate at 1.64%, the note’s miserly payout implies that if inflation meets investor expectations, the receipts from 10-year Treasuries will trail inflation by almost 1 percentage point per year. (The breakeven expectation seems credible, given that inflation over the past 10 years has been 1.9% annualized.)

(As the goal of investing is at the very least to preserve purchasing power, if not to outright increase it, then one could legitimately wonder if Treasuries at today’s prices are “investments.” Perhaps they should instead be regarded as an electronic version of mattress stuffing.)

To be sure, that 0.70% payout will look relatively attractive if yields fall further. In such a case, the Treasury note would increase in price, thereby boosting its total return. The math, though, remains unfriendly. For example, if Treasury yields were to hit zero in the year 2025, the 10-year Treasury would be worth $1,035. Its total return over that five-year period would be 1.4%--still below the level of expected inflation.

The question as to whether the traditional 60/40 allocation still applies is legitimate. The underlying assumption of balanced portfolios is that the bond allocation, although conservative, will also be profitable. That assumption faces serious doubt.

Bond Alternatives
Are there better fixed-income choices than U.S. government bonds?

Not really. Most domestic bond-fund categories yield more than do Treasuries, and thus likely have better long-term return prospects. However, as bond credit spreads are relatively tight, with the option-adjusted yields for BBB corporate bonds being a moderate 1.8 percentage points higher than those of Treasuries, the reward for assuming credit risk isn’t great. In addition, swapping government bonds for corporate bonds reduces diversification, since lower-quality securities move more in tandem with the stock market.

Heading overseas is no solution, as U.S. government yields exceed those of most other developed markets. For example, Japan’s 10-year government bonds yield a piddling 0.02%, while those of Germany, France, the Netherlands, and Switzerland have negative payouts. Unless the dollar weakens, thereby providing the international-bond investor with capital gains, the mattress would be an investment improvement! (Assuming, that is, that the bedroom doesn’t burn.)

One possibility, which I mention tentatively, is emerging-market government bonds, which yield about 4% and which for the major markets are very likely to be money-good. (China won’t default anytime soon.) Unfortunately, they tend to lose value when the global stock market dives, so they aren’t particularly good diversifiers.

Non-Bond Alternatives
Can alternative investments replace bonds?

Perhaps they can. I have long been skeptical of alternative investments, such as market-neutral, managed-futures, or currency funds, because their performances haven’t justified their additional risks. For example, among mutual funds, those three categories all failed to appreciate by even 1% per year over the past decade (through Aug. 31, 2020), while intermediate-term core bonds funds gained 3.6% per year.

That math has changed. True, it’s unclear whether alternative investments will beat bonds in the future, as opposed to joining them by treading water in nominal terms, while losing money in real terms. It could be, as has occurred over the past decade, that the profitable alternatives were cushioned versions of the stock market--long-short equity and options-based funds--while the alternatives that actually offered diversification went nowhere. That would be no help.

Nonetheless, in contrast with my earlier views, I would now consider using alternatives with balanced funds. Not as complete substitutes for bonds, but instead as partial replacements, along with other investments. For example, rather than the conventional blend of 60% equities/40% bonds, I might hold 60% equities, 16% bonds, 8% alternatives, 8% gold futures, and 8% cash. (This counsel is purely hypothetical, as I neither own a balanced portfolio nor advise clients.)

To What Purpose?
Should bonds remain part of the allocation if they only provide diversification?

Ideally, no. When holding a diversified portfolio of risky investments, one hopes that each asset class will pull its own weight. Otherwise, one could just own Treasury bills, which over history have posted a flat long-term real return, with their nominal performance essentially matching the rate of inflation.

Exceptions could be made for assets that consistently zig when the rest of the portfolio zags, thereby making the benefit from diversification so powerful that it can overcome modestly (but not strongly) negative returns. But Treasuries do not possess that attribute, as they tend to slide along with the stock market when inflation unexpectedly rises. High-quality bonds are an excellent hedge against recessions--but not necessarily against other causes of stock-market declines.

That said, one can only work with what the financial markets provide. Forty years back, investors could select from a wide variety of securities that offered high yields--bonds of all flavors, along with most stocks. They enjoy far fewer such opportunities today. In such a climate, buyers may swallow hard and continue to own Treasuries, solely to achieve diversification. Such a decision would make sense. However, as previously suggested, they probably will wish to cut their allocations, given today’s prices.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.