Since November 2008, when the Federal Reserve Bank announced its plan to make significant purchases of bonds, the bond buying programs known as quantitative easing have been significant drivers of movement in the bond market. Prior to 2008, observers would have predicted that the Fed’s bond purchases would drive bond yields down. The thinking goes like this: as the Fed gobbles up the supply of bonds, their price rises –and yields fall.
Indeed, that’s how huge purchases of bonds should affect the bond market. But when it’s the Fed doing the buying, it doesn’t work that way. Quantitative easing has actually driven bond yields up. Why? Theories abound, but many observers argue that it’s because when the Fed is doing the bond buying, it’s signaling it will take action to heat up the economy. And who wants to own bonds if the economy is booming?
For the individual investor, thought, tying a bond-investing strategy to what the Fed may or may not do and the outcome of that action is difficult. What the last six years have shown us is the age-old principles of bond investing – and the reasons to invest in bonds in the first place – still hold true. Those principles include predictable income, relatively infrequent and shallow losses, and diversification. Let’s take each in turn.
Predictability of bond income is measured by standard deviation – the amount of variation in annual bond yields over time. The lower the standard deviation, the more predictable the yield. And bonds are more predictable than stocks, on average. For example, between 1928 and 2013, the standard deviation of the 10-year Treasury bond was 7.8%, and the standard deviation of the 3-month Treasury bill was 3.1%. The standard deviation of the S&P 500, in contrast, was 20% (Source: New York University Stern School of Business, 2014).
Why are bonds relatively more predictable than stocks? Bonds are debt obligations; so unless the entity goes under, bonds are guaranteed to return the investor’s principal plus interest, which is typically paid twice a year. Of Course, the prices of bonds as they’re sold on the secondary market fluctuate, just like the prices of stocks do. But with bonds, you’re all but guaranteed at least regular interest and the return of your principal at the term’s end.
Of course, the higher rate of predictability bonds offer doesn’t come free. The trade-off is a lower rate of return. So while bonds were much more predicable than stocks between 1928 and 2013, they also generated lower returns. The average return on the 3-month T-bill was 3.6%, and the average return on the 10-year Treasury bond was 5.2%, while the average return of the S&P 500 was 11.5% (Source: New York University Stern School of Business, 2014).
Infrequent and Shallow Losses
On a year-to-year basis, the relatively higher predictability of bonds means that losses are more rare and more shallow. Over that period, the 3-month Treasury bill never generated a negative return – though during a number of years, its return was below inflation, meaning that investors were actually losing money in real terms. The 10-year Treasury bond yield was negative in 16 of the years between 1928 and 2013. Its deepest loss was – 11.1% in 2009. The stock market, in contrast, has 24 losing years between 1928 and 2013, with its deepest loss -43.8% in 1931; the second-deepest loss was -36.6% in 2008.
Because of income predictability and infrequent/shallow losses, bonds are effective at diversifying a stock-heavy portfolio. Because bonds are seen as safe investments when the stock market is declining, bond market and stock market returns tend to be countercyclical. For example, in 13 of the 16 years that the 10-year Treasury bond generated negative returns, stock market returns were positive. In 21 of the 24 years stock market returns were negative, Treasury bond returns were positive.
So, is bond investing in 2014 hot or not? It depends. If you’re looking for fixed-income stability – hot. If you’re looking for growth — not. Then again, it all depends on what the economy does. If the economy continues to strengthen, bond yields will likely remain low. Bu if the economy weakens, bond yields could rise again. The bottom line: It’s all about diversification. Please call if you’d like to discuss this in more detail.