Bonds Are Broken
Many investors rely upon bonds to provide a “safe” investment to offset the risk in the stock market. And historically, bonds have been a good bet. However, the yield of bonds has dropped significantly in the past ten years. Bonds are no longer the safe haven they were once thought to be. In the last thirty seven years, their yield has dropped from 15 percent to around 3 percent.
When the financial crisis hit in 2007 and several hundred-year old firms were on the verge of declaring bankruptcy, the Federal Reserve stepped in to help. The Fed pumped trillions into the treasuries and mortgage-backed securities markets and lowered interest rates, propping up an economy that threatened ruinous collapse. This economic stimulus has continued for several years and as a result the Fed’s balance sheet increased from 800 billion dollars to 4.1 trillion. The issue for investors is the Fed’s purchase of bonds drove up the prices and drove down their yields.
The Federal Reserve announced in late 2017 that it would shrink its balance sheet and would no longer be purchasing new bonds. The biggest buyer of bonds, the Federal Reserve, had driven the price up and yields down and artificially set the interest rate lower than market forces would generally dictate. As a rule, 10-year and 30-year Treasury Bonds are close to the nominal GDP (gross domestic product, a monetary measure of the market value of all final goods and services produced in a period of time). The nominal GDP is around 4.8 percent, and both 10-year and 30-year Treasury Bonds yields are around 3 percent. We believe yields will go up as the Federal Reserve stops buying. This means bond prices should go down as yields go up. The mix of higher yields and lower prices indicates total return on bond investments will remain low for the next five to fifteen years as yields and prices move to market based, not Federal Reserve manipulated prices. Expect total returns for bond investors to be in the range of 1.5 percent to 3.5 percent depending on the speed with rates and yields rise and prices fall. That’s a major trouble spot for the bond market. Who will buy those Treasury notes? That situation could lead to a sell-off in 10-year and 30-year bonds. While we do not know the timing of interest rate increases, we do know that rates will probably go up as market forces take over.
When an investment fails to yield enough to protect your capital, that investment is risky. Today, in addition to their low yield, bonds carry high interest rate risk. Existing bond holders will experience losses as rates rise. Bonds are also subject to inflation risk. With current yields at historic lows, bonds barely breakeven when you factor in inflation. This situation could get even worse as rates rise. Retirees depending on bonds to finance their retirement, may find themselves having to deplete their capital.
Bonds no longer work as a diversifying investment because the yield is too low, they don’t generate enough income, and they’re risky. A typical investor’s portfolio is comprised of mostly stocks and bonds, usually the very common 60 percent stocks /40 percent bonds mix. With the Barclays Aggregate Bond Index producing an expected yield of 3.1 percent, and the S&P 500 having a current dividend yield of under 2 percent, this investment strategy is likely to produce very little income for a portfolio.
Fortunately, there are other assets classes, non-correlated ones that can be introduced into a portfolio to lower volatility in the portfolio while providing a higher expected yield. The low interest rate environment we have experienced for most of the past decade has made it difficult for investors to generate income. It is not impossible to achieve a decent level of expected income from your portfolio. One solution is to look at alternative income producing investments to achieve a higher expected yield while maintaining a similar level of overall investment portfolio risk.
Tradition has developed such a strategy to provide clients with a higher expected income despite the low interest rate environment. Positioned as a bond substitute within a globally diversified portfolio, the bond substitute segment has the potential to improve a client’s income stream compared to a traditional bond portfolio while providing some protection in a down market.
This strategy is designed for investors seeking higher yields with lower volatility. Our strategy uses assets with low correlation to achieve high income for clients while controlling risk through diversification. The utilization of truly low or non-correlated assets such as Reinsurance, Private Real Estate, Alternative Lending, Timberland, Infrastructure, and Variance Risk Premium Harvesting strategies to achieve yield and increase diversification has profound effect on portfolio risk reduction. The Absolute Income Strategy has a current estimated yield of approximately 6 percent.
The bottom line is this. Bonds are broken, and if you expect to have a retirement that is sustainable and comfortable, you need to understand that and alter the traditional approaches that have served generations before you.
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