Many investors have been lured into bonds lately, impressed by their strong performance over the past 30 years, as bond prices rose with the dramatic fall of interest rates from double digits to multi-decade lows today (see Chart 1). In 2011, the Barclays U.S. Aggregate Bond Index returned 7.84 percent, 30-year Treasury bonds returned 35 percent, while the S&P 500 was basically flat for the year.
Chart 1. 30 Years US Treasury Bond Yield.
Investors chasing performance are bound to be disappointed. The current extremely low yields leave little room to go down much more, which means bonds past performance over the last 30 years simply cannot be repeated if you buy bonds today. Bonds at current prices are rank speculation, and can no longer be considered conservative or sound investments. If you are a long term investor, i.e. investing money you won't need for 10 years or more, sell all your high grade bonds now. Put 100 percent of your investable money into equities, or possibly junk bonds. Here is why high grade bonds no longer make sense for long term investors.
Bond price is inversely related to interest rate. To see why, say you buy a newly issued $1000 par value bond today at 3% coupon rate, then interest rate promptly falls to 2%. The bond you bought pays $30 yearly interest. To get the same interest amount from a newly issued bond with 2% coupon rate, you would need to buy $1500 worth of 2% coupon rate bonds, so your original 3% coupon rate bond must go up in price to reflect its better value. It will not go all the way up to $1500, because you get only $1000 principal back when the bond matures. Bonds with longer duration to maturity are more sensitive to interest rates, because the effect of interest payments outweighs principal repayment for longer duration bonds. To calculate the present value of your bond, use the discounted cash flow formula: present bond value = (annual interest payment)*(1-1/(1+current interest rate)^years to maturity)/current interest rate + bond par value/(1+current interest rate)^years to maturity. For our example, if you had a 10-year bond, its price would go up to $1089.83 as interest rate go down from 3% to 2%. If you had a 30-year bond, its price would go up to $1223.96.
The only reason bonds have performed so well is that interest rates have dramatically fallen to their multi-decade lows today. How much lower can interest rates go? Certainly they can't go below 0. The current interest rate is so low because the Fed has adopted an aggressive inflationary easing policy to keep asset prices buoyant and prevent a depression. It is obvious that there is not much room for interest rate to go down anymore looking forward, and that once the economy picks up steam, interest rates have only one way to go: up, and probably by a lot.
What is the Downside if Interest Rates Go Up?
To see how much damage investors in high grade bonds can suffer if they buy bonds today, at 2% yield for 10-year T-bond and 3% yield for 30-year T-bond, assume that interest rates merely return to their historic averages, about 4% for the 10-year bond and 6% for the 30-year bond. Price for the $1000 face value 10-yr bond with 2% coupon rate would fall to ($20)*(1-1/(1+0.04)^10)/0.04)+ $1000/(1+0.04)^10 = $162.22 + $675.56 = $837.78, a loss of over 16%.
Price for the $1000 face value 30-yr bond with 3% coupon rate would fall to ($30)*(1-1/(1+0.06)^30)/0.06)+ $1000/(1+0.06)^30 = $412.95 + $174.11 = $587.06, a loss of over 41%, which is a hefty loss for an investment that is supposed to be "conservative".
But if interest rates overshoot (as markets tend to overcorrect when they revert to the mean) and go to 6% for the 10-year bond and 9% for the 30-year bond, what happens?
Price for the $1000 face value 10-yr bond with 2% coupon rate would fall to ($20)*(1-1/(1+0.06)^10)/0.06)+ $1000/(1+0.06)^10 = $147.20 + $558.39 = $705.59, a loss of over 29%.
Price for the $1000 face value 30-yr bond with 3% coupon rate would fall to ($30)*(1-1/(1+0.09)^30)/0.09)+ $1000/(1+0.09)^30 = $308.21 + $75.37 = $383.58, a loss of over 61%! Note that this loss is even worse than that experienced by the stock market from the absolute top to the absolute bottom in the severe 2007-2009 bear market.
Of course, if you buy individual bonds and hold them onto maturity, these are only paper losses. But if you buy bond funds, such as AGG, BLV, BND, these losses are quite real.
Bonds Now Have Negative Expected Real Returns
Even if you avoid bond funds and buy individual high grade bonds only, bonds are still a bad investment right now. Inflation has averaged 3-4% per year over the past 100 years. The current multi-decade low bond yield won't even keep up with inflation. This is why Treasury Inflation-Protected bonds (NYSEARCA:TIP) now have negative yields. If you buy long term high grade bonds today, you have essentially bought a certain loss "investment".
Sell Bonds Now
A conservative investment is one most likely to conserve purchasing power at minimal risk. Bonds today offer potential for huge losses when interest rates go up, and they are yielding less than inflation today. Therefore, high grade bonds are no longer sound investments for long term investors.
Bonds are supposed to be straight forward investments: you buy them when they offer attractive yields. At today's multi-decade low interest rates, so low that they even fall below the average inflation rate, buying high grade bonds is a guaranteed loss. The only bonds worthy of consideration today are low grade bonds, also known as high yield bonds or junk bonds, and buying them only in a junk bond fund, such as JNK or HYG, for diversification against default risk. High grade bonds, especially those with long maturities, are only good for speculators now, but are toxic for the long term investors. For long term investors, regardless of age, 100% equity is the only conservative, safe, and sensible asset allocation for money they won't need for at least 10 years.