October 11, 2023:
In this article, we’ll discuss the history-making rise and fall in bonds and the potential opportunities that have resulted from it.
The rise (to exceedingly high prices)
Bonds don’t typically get much press, as the media and most people are more interested in stocks. (We wrote about stocks in our prior update). But bonds are an important part of the financial markets, and of many portfolios: the classic “moderate” allocation is 60% stocks and 40% bonds.
Investors have finally taken notice over the past couple years, as this usually-boring part of their portfolios has endured its biggest downturn in many decades.
As is the case with most of the worst market declines, this one was preceded by the investment getting very, very expensive. For a really big picture view, consider this very long-term chart of bond yields. (Bond prices move inversely to their yields, so low yields are equivalent to high prices and vice versa).
This chart doesn’t even show 2020, when bond rates reached their lowest levels (and highest prices) in 5,000 years! But there’s a strong counterpoint here: financial markets have come a long way since people were paying each other in sheep, so yields should be lower now than they were a long time ago.
So let’s just zoom in on the past two decades. Here’s a chart of the 10-year US Treasury yield since 2003. (We’re stopping this chart at the yield lows in 2020, because we don’t want to spoil the ending).
The 10-year Treasury yield dropped to just over .5% in mid-2020. This low point was admittedly reached during the Covid lockdowns — but by that same date, the US stock market had risen over 50% off its low, so it’s not like the market was pricing in some terrible economic outcome. 1
A good potential objection here is that it’s ok for bond yields to be low if inflation is also really low. So here’s a chart that shows the 10 year “real” yield — that is, the yield in excess of expected inflation over the next 10 years:
Here we see that Treasury investors were locking in more than a 1% per year expected loss after inflation. To make matters a lot worse, the market catastrophically lowballed its inflation forecast. At the yield low in August 2020, in the midst of unprecedented fiscal and monetary stimulus, the expected next-10-year inflation rate was less than 1.6%. That didn’t leave much room for inflation to rise — which it did, having averaged a 5.3% per year increase since that time. 2
In summary: we had all-time low yields (high prices), negative expected inflation-adjusted returns, and an inflation forecast that turned out to be extremely optimistic. What could go wrong?
Here are those last two charts updated through the present:
How have these yield moves translated to investment returns?
- An investor who’d bought a 7-10 year Treasury Bond ETF at the peak is down 23%, including interest income.
- It’s even worse for longer-term bonds, which are more affected by interest rate changes. Investors who bought a 25-year Treasury Bond ETF at the peak are down over 58% including income. This is as bad as the decline in US stocks during the Global Financial Crisis.
Given that yields were fairly low to begin with, these recent price declines have wiped out many years’ worth of prior gain. Even including interest income, the 7-10 year Treasury ETF has made no money since 2013 and the 25 year version is negative since 2008!
The opportunity now
As value investors, we tend to downplay stories and rationalizations that seem to justify recent price moves. Instead, we mainly focus on the numbers in a historical context. What are the expected returns for an investment based on its fundamentals and valuation? What risks are investors taking, and how much are they being paid to bear that risk? This approach can often seem wrong and out of touch for a long time, only to finally be validated.
The bond market of the past decade-plus provides a textbook example. The bond bull market lasted a very long time, during which bond prices went from reasonable, to expensive, and then well beyond. By the end, value investors who’d been suggesting that long-term bonds offered a lot of risk for not much reward looked hopelessly misguided. Then, rather abruptly, an entire decade’s worth of returns were painfully lost.
But that same type of value-based analysis suggests a very different situation today. The carnage of the past couple years has brought bonds from ruinously expensive to… actually kind of cheap!
Here’s the chart of the 10 year Treasury rate again. Yields haven’t been this high, nor prices this low, in over 15 years. (And with the exception of a brief spike during the 2008 crash, inflation-adjusted yields are also at 15 year-plus highs).
As a result, we have added bond exposure to our portfolios during the recent selloff. After years avoiding bonds because we thought they were too expensive, we are happy about this chance to buy at unusually high yields/low prices. (We’ve kept this discussion to US Treasuries to keep things simple, but we actually own a mix of government and high-quality corporate bonds yielding around 5.7%). 3
As always, this is not a market timing call. Yields could go higher in the near term. But rates at these levels have historically led to unusually good returns, so we want to take this opportunity while it’s available. 4
- All return stats via Koyfin (SPY for stock returns, IEF for 7-10 year Treasuries, and EDV for 25 year Treasuries). All data and charts as of 10/6/2023.
- Source: FRED. The annual inflation rate reached as high as 8.9% in July 2022, but it’s been trending pretty steadily downward since then, and was most recently at 3.7%.
- Source: S&P
- Given that cash rates are even slightly higher than longer-term bond rates, some readers may be wondering why we don’t avoid the potential volatility and just stay in cash. The answer is that cash yields are unlikely to stay at the current level for years, and if they decline, your interest payments immediately fall as well. We’d rather lock in these high rates for longer. To put it a different way: while cash rates might currently be higher than longer-term bond rates, our multi-year return expectations are higher for bonds than for cash.