Bonds have become less attractive in many corners of the investment markets in 2020 as rates have dropped to historically low levels. As a reminder, bonds can produce returns in two forms: 1) the interest they pay which is a product of the yield or rate they offer and 2) price appreciation. Historically, most investors have looked to bonds for their yields (the interest they pay) and for their stability. Over the past 40 years, bond investors have been richly rewarded with price appreciation as rates fell from double digit levels to near zero levels today. As another reminder, bond prices go up when interest rates go down while their prices decline when interest rates go up. With rates at or near historical lows, one isn’t wrong to think there’s a risk/reward imbalance in bonds to the downside given current rate levels. In other words, it appears there’s a lot more room for rates to rise than to fall from here. The problem is rates can stay low for very long periods of time as was the experience in the period that spanned 1934-1953. The US Treasury 10-year rate fell below 3% in June of 1934 and didn’t move above 3% until May of 1953 and not sustainably so until June 1956. That’s over 20 years! For the 60-plus years preceding 1934, the average 10-year rate was around 3.90%. As you know, that was an extraordinary period of time with the Great Depression and World War II, not to mention Federal Reserve actions, which included yield curve control where the Federal Reserve had an agreement with the Treasury to cap yields at certain levels in an effort to manage the debt service on the government’s wartime debt.

Today, many references have been made to the 1930-1950 timeframe and to the stagflation of the 1970s. I, like everybody else, am unable to predict what exactly will occur in the future and/or when it will occur. I think compelling cases have been made for why rates will stay lower and why rates will rise. The case for rates to stay lower longer is predicated on two main factors: 1) High levels of government debt that are expected to continue to increase for the foreseeable future and 2) A disinflationary (maybe deflationary?) environment due to a precipitous drop in economic activity that may take years from which to recover. The main drivers for rates to move higher are: 1) Higher inflation and 2) Weakening credit worthiness of the US government resulting from ever increasing debt levels.

Inflation is a fascinating phenomenon because we haven’t seen it in years and everyone is trying to predict when it will come back. While inflation has been elusive in headline numbers, I think it’s safe to say we’ve all experienced inflation in pockets of our lives that exceed the headline figures. I can’t say with certainty the weighted-average inflation in our lives is above national headline figures. However if an inflationary mentality takes hold among a large enough portion of the population, we may actually get inflation. According to Van Hoisington and Dr. Lacy Hunt at Hoisington Investment Management, most inflationary pressures are likely to be transitory given the high debt levels and anemic levels of economic growth. In their most recent quarterly review and outlook, they identify one potential tail risk that would lead to sustainably higher inflation. Specifically, if the Federal Reserve’s liabilities were made legal tender. In other words if the Federal Reserve began to directly fund government expenditures, versus simply lending, that would be a circumstance under which inflation would pick up and stay up irrespective of government debt levels and economic growth expectations.

A lot has been written about the changing dynamics in asset allocation and portfolio construction resulting from the bond issues we’ve discussed thus far. Basically, yields are too low to offer any sort of meaningful income and unless rates go negative there’s not a lot of price appreciation potential either. The problem here is that we’ve been spoiled for 40 years where bonds have been major contributors to portfolio returns as interest rates have declined from long-term cyclical peaks to all time lows. Not only were we able to earn relatively attractive yields, but we also greatly benefitted from substantial price appreciation. Now we’re faced with the potential reality that neither of those benefits will be available to us in the coming years.

So what purpose are bonds supposed to serve in an investment portfolio if income and price appreciation have the potential to be non-existent? What if rates begin to rise and price depreciation overwhelms in pick up in yield? This scenario presents quite the conundrum for asset allocators. If the main purpose of bonds in an investment portfolio are to generate income and price appreciation then we have a major problem. However, if bonds are supposed to provide stability then they still have the ability to serve that purpose unless of course rates start charging higher for any number of reasons. Even then, the Fed could implement yield curve control measures, which would effectively cap rates at certain maturities and in turn put a floor in for prices. I doubt a situation as just described would go down as smoothly as stated but if investors believe the Fed will cap rates they may be more willing to hold bonds or to not sell them.

The sad reality is we all currently need to lower our return expectations over the medium to long-term for both stocks and bonds. While growth is paramount in investment portfolios, capital preservation is equally if not more so. Regardless of return expectations, investment portfolios still need bonds whether it be government, municipal, corporate or some combination of the three. Bonds bring stability to investment portfolios which may be very welcomed in what could be a very volatile future.