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The 5% Problem

June 18th, 2013
in contributors

Double Jeopardy for Traditional Bond Investors

Q&A by Nathan Rowader, Forward Markets

Highlights

Investors have suffered with low yields, but profited from rising bond values during the 30-year bull market for bonds.

We believe the bond market is moving into a bearish phase, putting the value of existing bond holdings at risk.

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Investors have been conditioned to believe that traditional bonds are safe and can deliver 5% annualized yields over the long term. In the current climate, neither may be true.

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A variety of income-producing options are available for those who want to diversify bond portfolios and seek better yields.

Historical analysis shows that a diversified portfolio would have outperformed traditional bonds during the last bear bond market and in periods of rising interest rates.

Follow up:

•• Exactly what is the 5% problem? And why should investors be concerned about it?

The 5% reference is to the historical average annual yield for traditional bonds - that is, U.S. government bonds, including Treasury notes and bonds-from the beginning of 1926 to the end of 2012.[1] The problem is that investors have grown accustomed to earning those kinds of yields, or better, from bond investments that carry little or no risk of default, such as U.S. Treasurys. But over the last couple of years, yields have been in the zero-to-2% range and the risks of bond investing have risen sharply.

So you could say it's a time of double jeopardy for bond investors. First, they need to worry about finding the kinds of income streams they need to keep their financial plans and retirement on track. But they also need to be aware that their portfolios may be exposed to a level of risk that is far out of proportion to the income that traditional bonds are generating. Many investors still think of traditional bonds as "safe" when that may not be the case at all.

•• What has changed? Why do you believe the bond market climate has become so much riskier?

We're now more than three decades into the bull market for bonds. That means bond prices have been rising while yields have been steadily dropping-those two factors always move in an inverse relationship, as most investors know. When the bull market started, back in 1981, the annual yield from a traditional bond index was in the neighborhood of 14.8% (Figure 1). If you look at 10-year Treasurys now, they're yielding less than 2% in annual income, and if you adjust that yield for inflation, it has actually dipped below zero (Figure 2).

Figure 1. The Bond Bull Market Has Run More Than Three Decades
Yield of the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index
October 1, 1926 – December 31, 2012

Source: Ibbotson Associates
Past performance does not guarantee future results.

Figure 2. Real Treasury Yields Have Dipped Below Zero
10-Year Treasury Yield, Inflation-Adjusted
February 28, 2003 – December 31, 2012

Source: Ibbotson Associates
Past performance does not guarantee future results.

Because bond prices have been rising, total returns have been good, averaging 8.8% annually over about the last three decades, and 5.8% over the past 10 years. That performance has lulled investors into feeling they are on solid ground with traditional bond investments.

It is critical to recognize, however, that traditional bonds' ability to deliver positive real returns over the past 30 years has been due in part to the steady rise in bond values during the bull market. Based on the Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index, appreciation accounts for 40% of total traditional bond returns between October 1981 and December 2012 - nearly twice as high as the historical average since 1926 of 15%.[2]

If the climate shifts to a bear market for bonds, bond prices will drop - and that could mean major losses in portfolio value for investors with existing bond holdings. The impact could certainly be enough to derail investors' financial and retirement plans.

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With rising bond prices, total returns have been good, lulling investors into feeling they are on solid ground with traditional bonds.

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♣♣ How we measured bond performance

Throughout this paper we rely primarily on two metrics for historical U.S. bond performance:

♣♣ The 10-year U.S. Treasury note (referred to as "Treasurys") is the benchmark we use when discussing relatively recent government bond performance (that is, over the past 20 or 25 years).

♣♣ The Ibbotson Associates SBBI U.S. Intermediate-Term Gove rnment Bond Index, a broad-based index of 5-year U.S. bonds, provides a longer time series of bond returns. Thus, we used this measure when discussing longer-term historical trends.

We use the term "traditional bonds" to refer to U.S. government bonds, including Treasurys, that carry little or no risk of default, in contrast to higher-yielding corporate or municipal bonds.

•• Are you saying that the bull market for bonds is over?

I believe so, and I am by no means alone in that belief. Some analysts say we shifted to a bear market for bonds back in July 2012, when 10-year Treasury yields hit a long-term low of 1.4%. Whether you agree with that or not, it's clear that interest rates must eventually rise-they really have almost nowhere else to go.

Of course, no one can say what the Federal Reserve will do, or when. But if the economy improves and job creation picks up, I believe we're likely to see somewhat higher rates of inflation, which could spur the Fed to begin raising interest rates sooner rather than later. My view has also been influenced by the changing relationship between 10-year traditional bond index and stock market returns (Figure 3). The spread between the two has more or less disappeared in recent months. That is significant because under most conditions, stocks outperform bonds over a 10-year period-and when that's not the case, the trend usually corrects itself fairly quickly, as we saw in the 1940s, '70s, and '80s. In fact, the current pattern is almost identical to the one we saw back at the start of the last bear bond market in 1941.

Figure 3. Diminished Return Spreads Point to a Bond Market Shift
Relative 10-year Return of Stocks vs. Bonds, Period Ending December 31, 2012

Source: Ibbotson Associates
Past performance does not guarantee future results.

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The risk of losses in bond value due to a rise in interest rates could potentially exceed the annual after-tax income from bond investments.

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•• When you talk about risks, is it mainly those connected with rising interest rates?

That is certainly the biggest and most immediate cause for concern. Our analysis shows that the risk of losses in bond value resulting from a rise in interest rates could potentially exceed the annual after-tax income from those investments (Figure 4). Think about what that means: if you bought a Treasury bond today and interest rates then rose just 10 basis points, the resulting loss of bond value would wipe out an entire year's worth of returns.

Figure 4. Risks from Higher Interest Rates May Exceed Reward Potential
Annual After-Tax Bond Income vs. Risks of Loss in Bond Value from a 1% Rise in Interest Rates, based on an investment of $1 million, as of January 1, 2013

Note: Assumes 39.6% Federal and 3.8% Affordable Care Act tax rate; does not include state/local taxes.
Sources: Asset classes in the chart above are represented by the following indexes: Muni High-Yield—Barclays High-Yield Municipal Bond Index; U.S. Corp High-Yield—Barclays U.S Corporate High-Yield Index; Municipal Bond—Barclays Municipal Bond Index; U.S. Mortgage-Backed Securities—Barclays U.S. Mortgage Backed Securities Index; U.S. Credit—Barclays U.S. Credit Index; U.S. Treasury—Barclays U.S. Treasury Index.
Past performance does not guarantee future results
.

Figure 5. Investors Have Gravitated to Bonds Despite Falling Yields
Annual Net Asset Flows into Bond Mutual Funds vs. Equity Mutual Funds, 1986 – 2012

Source: Investment Company Institute
Past performance does not guarantee future results.

But let's not forget about inflation. That's a more insidious risk, because rather than suddenly erasing a chunk of portfolio value, it chips away at it by degrees. Then, years down the road, you realize that you've lost a lot of the purchasing power you thought you had. This risk hasn't been very prominent in investors' minds because we've been in a low-inflation environment for the last 30 years. Since 1981, the Consumer Price Index has risen just about 3% a year, on average[3] - which is as you would expect in a bull bond market, since low yields and low inflation tend to go hand in hand.

The thing is, Treasury yields are already lagging inflation now. If consumer prices start ratcheting up, we could see an even greater negative real return on Treasurys.

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