On Bonds

Bonds have a math problem. It is unlikely that the next 40 years of returns will look anything like the last 40 years. In 1981, the yield on the 10-year treasury was north of 15%. As of December 15, 2020, the yield on the 10-year treasury is .92%.

Bonds have an inverse relationship with interest rates. This means that when interest rates go down, the value of bonds go up and vice versa. Generally speaking, rates have been declining for the last 40 years providing a tailwind to bond investors. It is unrealistic to assume that rates will continue to decline at such a pace going forward. Investors used to think that rates could not go below zero but believe it or not, there is currently $18 trillion of negative yielding bonds in the world today. Investors will actually get less back than what they put into it. So, while rates are still positive in America, it is not impossible that they go negative.

There are two main ways bond investors make money. The first is obvious. If you buy a 10-year treasury (or any bond) at par that yields .92% and matures in 10 years, you know exactly what you will make if you hold it to maturity. The second way to make money is a little more obscure. If interest rates decline, using the example above, you can make more than the .92% if you sell before it matures. Banking on a significant decline in interest rates seems unrealistic because there has to be a limit to how negative rates can go. At some point, investors will not accept the terms.

The question is, where do rates go from here and how quickly will they move? This is not an easy question to answer because we are in unprecedented times. The Federal Reserve seems determined, at least at this point, to keep rates low for an extended period. That being said, if the economy were to take off, rates could move higher.

How do you invest in this environment? Defined Outcome ETFs could provide an acceptable alternative to bonds. While they are equity investments, they provide some downside protection in exchange for a cap on the upside.

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On Bonds