A Grim Intermediate Outlook For High-Quality Bond Returns

by: Sungarden Investment Research

Stock prices are driven by a variety of factors, including measures of valuation (price-earnings ratios, etc.), company-specific news and human emotion. Bonds on the other hand are more about simple math. A bond is essentially a contract to pay you a certain amount of interest, and pay you back a stated amount (the "par value") when the bond matures on a predetermined date. This creates a big problem for retirees and pre-retirees.

To assess the potential ramifications of the relationship between interest rates and bond prices, we examined the 10 year U.S. Treasury bond, the security of which most other types of bonds are priced. Using an industry standard calculation called "modified duration," we estimate that for every 1% increase in yield, the price of the 10 year Treasury will fall about 8.5%. This decline would be offset in part by the interest the bond pays during each year. Next, we considered what would happen if an investor bought 10-year Treasury Bonds and held them for five years, as we consider that term to be a sufficient period to measure the results of an investment.

Effects of Yield Changes on 5 Year Returns

Source: Sungarden Investment Research 2014

As the table above illustrates, an increase of only 1.5% in the yield of the 10-year Treasury from the 3.0% yield (which it traded at in late 2013) to 4.5% will essentially wipe out the annual 2.75% income return of the bond over the next five years. The key point is that high quality bonds offer at best weak upside return potential from these low interest rate levels, unless rates were to fall to near zero percent (in which case you'd earn a 7.42% annualized return), a predicament which would likely bring a separate set of challenges for retirees. If the reverse were to occur as the table below shows, interest rates can change significantly over a five-year period. In extreme cases, interest rates have changed by as much as 6.5%. Some critics of this analysis will quickly point out that if the investor simply held the bond for the full 10 years, they would earn the interest rate each year (2.75% in this example) and get their principal back.

Five-Year Rolling Change in 10-Year Treasury Rates

Source: Sungarden Investment Research 2014

That is absolutely true (assuming the Treasury doesn't default, but let's not go there). However it's easy to sit here today and say that one would be happy with a return of 2.75% a year for 10 years, not knowing what the future holds for the global economy, cost of living changes, individual liquidity needs and the risk of "performance envy" as other types of investments outperform Treasuries. Easy to say, but unlikely to occur. Flesh-and-blood humans have emotions and the possibility of "buyer's remorse" in this situation is very high. And if remorse is to occur, it is likely that rising interest rates over the investment period are the culprit.

Remember that rates have been steadily falling since the 1980s. A simple "reversion to the mean" in which rates rise toward their long-term average (the average 10-year U.S. Treasury rate since 1926 according to data sourced from the St. Louis Federal Reserve's website) would mean that rates would rise to about 5%. That's almost a 2% increase from where we are right now. We suspect that would be more than enough to spur a dramatic change in investors' attitudes toward bond investing, and to increase interest in viable alternative strategies for retirement income.

Disclosure: No positions.

Disclaimer: The views and opinions contained in this article are entirely those of Rob Isbitts of Sungarden Investment Research. This commentary is provided for information and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Past performance is not indicative of future results. Rob Isbitts is an investment advisor representative of Dynamic Wealth Advisors, a SEC registered investment advisor.