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Summary

  • Just because yields are low doesn't mean that they have nowhere to go but up.
  • The last time we had crippling government debt and historical low yields, they stayed low for a decade and then some.
  • We'll apply the yield hikes of the 1940's and 50's with today's yields on Treasuries to see what kind of performance we would receive.
  • While bonds offered muted returns in the 40's and 50's the stocks came to their defense.

Yields are low. Not the lowest they've ever been, but they are scraping the bottom of the yield barrel. There's not much coming in the way of income, and those bonds might not have much potential for growth on the price side of the equation. Today's environment for bonds seems to suggest that bonds still offer traditional risk management in a balanced portfolio, but they are not offering up much by the way of income and perhaps total return potential.

In a previous article I asked How Bad Could It Get For Bonds? The worse period was the mid 70's to 1980's when central banks wanted to slay the stagflation dragon. Yields on 10 year Treasuries went from 7.39% in 1976 to 13.42% in 1981. The annual price declines ranged from 3% to 12%. The only component helping when bond prices take a hit is the yield. Today the yield on the 10 year is a paltry 2.35%. Given today's yield environment, similar rate increases could deliver initial annual price hits up to 15% for 10 year and closer to 18% for 20 year Treasuries.

Stagflation of the 70's (when nothing worked) as I demonstrated in this article was certainly an outlier period. There's the probability that if or when rates rise we will see more of a gradual increase, at least that's what bond history (and long-term charts) are trying to suggest.

Just because rates are near historic lows does not mean that they have to go up at all, can't go lower, or that rates have to spike violently. They might repeat this pattern from 1943 to 1955.

Year

Treasury 5 -year

Treasury 10 -year

Treasury 20 -year

1943

1.22

1.80

2.20

1944

1.17

1.79

2.20

1945

1.02

1.59

2.10

1946

1.02

1.56

2.00

1947

1.39

1.93

2.20

1948

1.59

2.05

2.30

1949

1.49

1.93

2.20

1950

1.71

2.15

2.40

1951

1.99

2.41

2.60

1952

2.23

2.58

2.80

1953

2.05

2.57

2.70

1954

1.79

2.52

2.70

1955

2.23

2.67

2.80

There are two obvious observations. One, rates did not go anywhere in a hurry. Two, Treasuries were not particularly good investments on the total return front. As always investors of the day (largely institutional) would have been using bonds to moderate portfolio risk or volatility.

Here are the annual price hits or increases for that period on the 10 year Treasury.

Year

Treasury 5 -year

Treasury 10 -year

Treasury 20 -year

1943

1.22

1.80

2.20

1944

1.17

1.79 (0%)

2.20

1945

1.02

1.59 (+1.6%)

2.10

1946

1.02

1.56 (0%)

2.00

1947

1.39

1.93 (-3%)

2.20

1948

1.59

2.05 (-1%)

2.30

1949

1.49

1.93 (+1%)

2.20

1950

1.71

2.15 (-2%)

2.40

1951

1.99

2.41 (-3.1%)

2.60

1952

2.23

2.58 (-1.4%)

2.80

1953

2.05

2.57 (0%)

2.70

1954

1.79

2.52 (0%)

2.70

1955

2.23

2.67 (-1.2%)

2.80

Rates were essentially flat nudging up only gently. In fact that would be the perfect environment for bond investors. I would certainly like to see rates nudge higher delivering more yield to the portfolio, with only modest price hits along the way that eventually are compensated for with bond laddering, and adding those higher yielding bonds along the way. But certainly the environment would have presented very muted bond returns. If one was holding a balanced portfolio the stock markets would have taken care of any portfolio value concerns.

As I will repeat several times a day, we should not look at stocks and bonds in isolation. There's no guarantee that they will pick each other up, but there's a very good probability that they will work together to moderate volatility and in most periods eke out gains in trying times.

While the early 40's to mid 50's delivered a period of very gentle rate hikes, and the 70's delivered that violent spike, there's the potential for modest rate hikes.

Here's 1955 to 1970.

Year

Treasury 5 -year

Treasury 10 -year

Treasury 20 -year

1955

2.23

2.67

2.77

1956

2.95

3.03

3.00

1957

2.85

3.13

3.24

1958

3.02

3.43

3.62

1959

4.04

4.20

4.17

1960

3.86

4.18

4.15

1961

3.44

3.99

4.03

1962

3.51

3.99

4.06

1963

3.68

4.01

4.07

1964

4.00

4.17

4.17

1965

4.40

4.43

4.38

1966

4.66

4.59

4.51

1967

4.97

4.99

4.91

1968

5.77

5.74

5.69

1969

7.01

6.75

6.42

1970

6.45

6.75

6.41

And here's the annual (and initial) price declines on the 10 year. Of course, the price declines lessen as the bond gets closer to maturity.

Year

Treasury 5 -year

Treasury 10 -year

Treasury 20 -year

1955

2.23

2.67

2.77

1956

2.95

3.03 (-3%)

3.00

1957

2.85

3.13 (-1%)

3.24

1958

3.02

3.43 (-2.3%)

3.62

1959

4.04

4.20 (-5.7%)

4.17

1960

3.86

4.18 (0%)

4.15

1961

3.44

3.99 (+1.4%)

4.03

1962

3.51

3.99 (0%)

4.06

1963

3.68

4.01 (0%)

4.07

1964

4.00

4.17 (-1.2%)

4.17

1965

4.40

4.43 (-2%)

4.38

1966

4.66

4.59 (-1.2%)

4.51

1967

4.97

4.99 (-2.9%)

4.91

1968

5.77

5.74 (-5.2%)

5.69

1969

7.01

6.75 (-6.7%)

6.42

1970

6.45

6.75 (0%)

6.41

On the stock side, the Dow (NYSEARCA:DIA) went from 400 in 1955 to 680 in 1960. Here's the next 20 year period for the Dow 1960-1980.

(click to enlarge)

The bond market would have provided some stability and muted returns during years when the stock markets pulled their hissy fits, especially in 62-63 period. There were certainly opportunities to trim excessive moves and price gains from stocks, and move to bonds and cash. That's always something to consider as we hit price tops as I suggested in this recent article, There's No Money To Be Made From Here, Maybe. A balanced portfolio with disciplined rebalancing is always prudent for those who need to manage risk.

Looking back over the period of 1943 to 1970 it becomes evident that it was not that scary a period for the patient bond investor who stayed true to his or her commitment to bonds, and especially to bonds within a balanced portfolio. Bonds added stability to the balanced portfolio and they delivered rising income for reinvestment for those who were reinvesting on a regular schedule. Any reenactment of that period would be welcome by many, especially retirees who count on stock dividends, cash and bond income to fund retirement.

And of note, within that 28 year period there was only one occasion of a 1% yield spike. Interestingly, 2013 delivered a 10 year spike above 100 basis points. In 2014 the yields have been trending downwards, once again.

What's in store for the bond market?

Of course we have no idea what will happen with the stock or bond markets this year or next. But for those who need bonds for risk management, stay the course. If you need bonds, you need bonds. Investing principles do not change because yields are low. But we should always understand the risks and that's why I penned these last two articles. And as always I would suggest we never look at stocks and bonds in isolation. It's about the big picture, the long-term picture. It's about adopting an investment plan and sticking to it. When we react to market noise and predictions, we can make mistakes, we can leave money on the table.

Prudence is a quality we want to embrace. Fear can stay out of it.

And what can we do to manage the risks? As I stated in How Bad Can It Get, we can stick to the shorter end of the yield curve. You can ladder your bond portfolio, or purchase a laddered bond fund or a broad-based bond fund with a sensible duration. As always, invest on a regular schedule and purchase your bonds or bond funds on a regular basis. We know we have to purchase stocks when they are going down in price, ditto for bonds. Many also suggest that you diversify by adding higher-yielding bonds to the mix. They can be less reactive to rates and can act more like stocks at times, and of course, they will usually deliver a juicy yield. Or one can also move to cash for their fixed income and ladder CD's. If rates rise you'll be buying that higher yield on a regular schedule.

As for longer term treasuries (NYSEARCA:TLT), they will still likely deliver the ultimate hedge to major stock market corrections and they may still have a place in your portfolio. TLT may offer up a wonderful rebalancing opportunity in the next market correction.

This may be a period where "nothing looks good." Stocks are certainly somewhat overpriced, bonds are not in a great position. That's likely the most compelling reason to hold that nice mix of stocks and bonds, the money has to flow somewhere. And maybe gold will have its day again? Who knows?

Happy investing, and be careful out there.

Dale

Source: What If We See The 1940's All Over Again?

Additional disclosure: Dale Roberts is an investment funds associate at Tangerine Bank (formerly ING Direct). The Tangerine Investment Portfolios offer complete, low-fee index-based portfolios to Canadians. Dale's commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process