Most of today's bond investors have enjoyed a relatively stable, if unspectacular environment of strong annual compound returns. For the last 32 years, bond yields have fallen, which means prices have risen, as inflation has steadily declined, enhancing the real total return. Similarly, investors with traditional "balanced" portfolios featuring some mix of stocks and bonds have benefited from the low volatility and strong returns bonds have provided, even during periods when stock returns suffered.
Recent excitement in the bond market, which we have discussed in the last few month's letters, reminded investors what happens to portfolio returns when yields rise, as they did on the 10-year Treasury note from 1.6% to 2.6% over just two months in May and June, where they stand today. Understandably, such action has sent many bond investors scrambling, pulling a net $78 billion from bond mutual funds in the seven weeks ended July 17, according to Investment Company Institute estimates.
With inflation expectations remaining subdued, particularly in light of the talk surrounding the Fed's consideration of tapering the amount of future bond purchases, the current rise in yields is more about the fear that the Fed may be losing its perceived control of the bond market. From our standpoint, the rise in yields may signal the end of the "free lunch" of consequence-free monetary expansion.
As the Fed continues down its current path of monetary expansion, we maintain that future inflation is a matter of if not when. With a commitment to fighting the deflationary forces of debt deleveraging, combined with the likelihood of ongoing deficits as a result of demographic challenges, the Fed will not stop until the real burden of debt has been reduced. At the same time, fragility in the financial system, widespread bond ownership amongst current and future retirees, high leverage on consumer and corporate balance sheets, the government's need to fund the deficit, and the importance of a still fragile housing recovery, each point to a policy aimed at keeping nominal interest rates low for an extended period.
With that in mind, this month's Insight will take a look at the performance of bonds during two previous inflationary periods, the 1940s and the 1970s, and illustrate two very different total return experiences. Through these examples, we will show that bond investors-- and by extension, any investor with a traditional balanced portfolio, should not fear rising rates as much as they should fear perpetually low rates.
Bond Returns and Two Very Different Bond Bear Markets
The chart above shows the history of long-term interest rates and inflation between 1928 and 2013, and covers the history inflationary periods we are discussing.
As most people know, the 1970s featured rising inflation and generally rising interest rates. It was a fairly hostile environment for bond investors, particularly toward the end of the decade when bonds became known as "certificates of confiscation," owing to their inability to keep up with rising inflation.
Yet, during the 1970s, high current income in the form of coupons, helped to virtually eliminate any nominal losses from rising yields and falling bond prices. This is shown by the green line in the chart above. While real returns, shown by the blue line above, were far more challenged, between 1970-1978, as yields rose from 6.4% to over 9% and even with inflation averaging 6.8% per year, the real inflation adjusted return on the portfolio was still positive. It wasn't until the additional step up in yields and high inflation years of 1979 and 1980 when 10-year Treasury bonds started registering significant real losses, about 20% over the period. Furthermore, it took just two years to recoup these real losses. Holders of bonds, precisely because yields were high, were afforded some measure of protection against the risk of further rising yields as well as inflation.
The bond bear market of the 1940s, on the other hand, was very different as the Fed bought Treasury bills, notes and bonds in an effort to cap interest rates. At the time, it was considered a matter of national security to stabilize interest rates as the federal government's debt climbed from $33 billion in 1936 to over $260 billion by 1950; debt-to-GDP peaked at 112% of GDP during WWII, and by the end of the war the Fed held all outstanding Treasury bills. The Fed continued to keep rates low, below 2.5% on long-term bonds, all the way until 1951. In the paper linked above, Barry Eichengreen and Peter Garber argue that policy makers also kept rates low to minimize perceived threats to the banking system, owing to their large exposure to bond-market risk. The parallels to today are striking, which we'll discuss in greater detail below.
If bonds investors thought they had it rough in the 1970s, they had nothing on their predecessors in the 1940s. Because rates were held stable by the Fed, there wasn't much of a threat to nominal losses for bond holders-but because they were held stable at a low level, there also wasn't much of a chance for current income from the bond coupons to offset any real losses from inflation. Real returns were challenged for most of the decade, and not just from wartime inflation:- from 1940-1949 bond investors lost over 32% of the real value of their investment, with the majority of that loss coming in the last few years of the decade. Worse, the buy and hold investor locked in those low rates, ensuring no real gain all the way through the 1950s.
The lesson from these episodes is clear-in the context of an inflationary environment, bond investors should not fear rising rates; they should fear perpetually low ones. The problem facing today's bond investors-which includes anybody with a traditional balanced strategic asset allocation-is that perpetually low interest rates is exactly what policy makers need in order to achieve their objectives.
At the same time, as we detailed more recently in our July 2013 Strategy Letter, demographics suggest that future production growth may be more challenged just as promises made to an increasing number of retirees comes due. The result is an ever increasing challenge for government budgets and thus the likelihood of persistent structural deficits. Persistent structural deficits raise questions about the government's ability to service and repay debt with dollars of the same value. As Alan Greenspan reminded us, "we can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power." That is why money printing-and inflation-is a key component of financial repression in our policy makers' toolbox.
At the end of the day, the Fed wants Fed's goal is to reduce the real burden of debt. By definition this means handing bond investors real losses. Because nominal losses in the here and now, in the form of write-offs, defaults, restructurings, and the like are painful, politically difficult, and challenging to our over-financialized economy, the Fed is opting for the more politically expedient and time-tested method of inflation through currency devaluation.
The most effective way to reduce the real burden of debt and hand bond investors real losses is to simultaneously create inflation and keep interest rates at an artificially low level. This is the path of least resistance for policy makers.
Disclaimer: The content is provided as general information only and is not intended to provide investment or other advice. This material is not to be construed as a recommendation or solicitation to buy or sell any security, financial product, instrument or to participate in any particular trading strategy. Sitka Pacific Capital Management provides investment advice solely through the management of its client accounts.