Most investors realize that interest rates are at extreme historic lows. It’s no secret that the Fed has recently championed lower interest rates in an attempt to encourage business growth and development in a weak environment. Low rates theoretically allow businesses to reduce borrowing expenses and increase investment. Similarly, low rates encourage people to purchase big ticket items (cars, houses, flat-screen televisions, etc.) or refinance their mortgages to free up spendable cash.
Using 10-Year US Treasury bonds as our proxy for interest rates, we see that today those bonds yield just 1.6%. That’s a stark difference from when yields peaked in the early 1980’s at over 15%.
The decline over the past three decades from those higher rates to modern day low rates is dramatic and has far-reaching implications.
First, on the positive side, anyone who invested in just US Treasuries since 1980 has enjoyed a wonderful ride. US Treasuries are considered to be “risk free”, as the US Government has never defaulted on a coupon or principal payment. From January, 1980 – December, 2011, the Barclay’s Capital US Treasury Intermediate Bond Index returned an annualized 7.93%, turning a $100,000 investment into a little over $1.149 million with about 1/3 of the volatility of the stock market.
But that was yesterday. Today, retired folks who are dependent on income from savings accounts and certificates of deposit are clearly feeling the most pain from this interest rate squeeze. Low interest rates affect other types of investors as well. Bonds make up a good chunk of the portfolios of college and charitable endowment funds, which have had to cut programs to meet budget constraints due to reduced portfolio income. Institutions like insurance companies and pension fund managers also depend on income generated from large bond portfolios to meet their obligations to policyholders and retirees. And individual investors who have branched out from savings accounts and CDs into bond mutual funds to try to find extra income find those funds yielding very little.
Moreover, the 30-year “bull” market in bonds has lulled many individual investors into a false sense of security, particularly with the stock market declines of the early and late 2000s still fresh in their minds. Bonds appear to offer reasonable returns without the dramatic ups-and-downs of the stock market…but those returns were accomplished because rates were falling. Bond prices and interest rates move in opposite directions: when rates go down, bond prices go up, and vice-versa.
Given the low level of interest rates, it’s hard to imagine rates going much lower. Eventually they will shift higher, and current bond prices will fall. If interest rates go up by 1%, the prices of existing Intermediate-Term US Treasuries will fall by about 7.5%. That’s not a guess or a forecast. It’s a mathematical certainty, and it doesn’t sound “risk free” to us.
Woodward Financial Advisors has taken steps in our portfolios to lessen the impact of steep rate increases. We have emphasized shorter-term bond funds, which won’t drop as much as funds containing longer-term bonds. We have diversified our bond portfolios outside of just US Government bonds (which are very sensitive to interest rate changes) to include corporate and international bonds. Lastly, we have incorporated “alternative” investments (as in “alternatives to stocks and bonds”) to provide other sources of return in our clients’ portfolios.
There’s no telling when interest rates will increase to a more normalized range, we just know that they will. Bonds should continue to play a role in your portfolio for the diversification and volatility dampening effects they provide. But don’t count on them to deliver risk-free returns indefinitely.
 Before taxes and inflation
 As measured by the Barclays 7-10 Year Treasury Index
 A bond or bond index’s duration measures the change in price that would result from a 1% change in interest rates. Currently, the duration for an Exchange Traded Fund that tracks the Barclay’s 7-10 Year Treasury Index (IEF) is 7.53.