Historically, bonds in a portfolio have been thought of as a means to both generate income and to provide a deflation hedge in the case of a market correction or downturn. Since the early 1980s when interest rates hit their historic peak, bond values have been buoyed by a relatively steady downward trend in rates that has supported principal values.
With the U.S. Fed in a cycle of rate hikes to the overnight lending rate, there is a narrative in the media that bonds are no longer attractive investments. We are hearing from many clients that they’re concerned about the effect of rising rates on their bond holdings, and anxious that they could experience outsized losses. While it is true that the Fed is raising the overnight rate, it is the market (not the Fed) that determines the rates on any bonds with lengthier maturity dates. In reality, rates on longer dated bonds are not increasing at the same pace.
We think that this fear of rising rates is one of the most unsupported and exaggerated investment themes in memory, and we’ll offer some historical evidence that shows that most investors have far less to fear than they think.
Historically, economic growth and inflation have been the primary drivers of interest rates.
First, the prospect of a extended rise in interest rates seems a bit misplaced. Interest rates have historically been affected by two primary factors in the economy: economic growth and inflation. It is my position that we are unlikely to see either take off to the upside in the foreseeable future. So let’s take a closer look at these two factors.
Economic Growth – To be sure, we recently experienced an uptick in economic activity for the second quarter as compared with the last several years, with 4.1% Gross Domestic Product (GDP) growth. This is the economy’s third-best performance in the last 30 calendar quarters, and follows 12 quarters of growth in the 0.4% to 3.0% range1.
That said, it’s difficult to conclude that we will experience sustainable above-average growth for any extended period of time. Why not? Because economic growth itself is driven largely by two factors: growth of the workforce and productivity gains. Unfortunately, both employment numbers and demographics would appear to limit the number of additional workers that can be added to the economy, and achieving sufficient productivity to both offset the labor shortage and fuel growth seems unlikely.
Workforce Growth – At present the economy appears to be at or near what is considered to be full employment. In fact, the unemployment rate stood at 3.7% in September, a 48-year low according to the Bureau of Labor Statistics. Historically, economists have believed that a rate of 5.0% unemployment signified full employment of the available productive workforce. More recently, Federal Reserve economists put the number at 4.1%-4.7%. Either way, with such low unemployment the supply of productive workers is limited. In addition, demographics appear to present a challenge to workforce growth. Currently, the largest cohort of workers in our lifetimes, known as the Baby Boom generation, is in or nearing retirement. With birth rates since 1995 at slightly more than half of what they were in 1960 (the tail of the Baby Boom generation), the supply of new workers to take the place of Baby Boomers isn’t sufficient to spark growth of the labor force.
Productivity Gains – Loosely defined, labor productivity is the rate of productivity per worker, per unit of time. American workers do produce the most economic activity per worker of any economy in the world3. The challenge is not that we are not productive, but rather it is maintaining the growth of productivity that we achieved through the years of the working Baby Boom generation. Technology does drive productivity gains, however there seems to be a seven year lag between capital spending on technology and the realization of those gains. Unfortunately, despite a recent uptick, capital spending on technology has been light since the financial crisis of 2008.
So, we’re faced with some meaningful challenges in achieving sustainable growth of the economy, which can contribute to higher interest rates.
Inflation – We all think that prices are higher than they should be. Prices for food, heating oil, gas and travel seem to be ever increasing. But to a large extent, prices of those products are influenced by the price of crude oil, which we know can be very volatile. Core Inflation (which excludes the effect of energy and food prices) seems quite tame. Many of us can remember the days in the early 1980s of 10-11% inflation; however, as measured by The Bureau of Labor Statistics, the annual rate of core inflation has not exceeded 3.0% since 1995. Looking ahead, we do not expect robust inflation in the foreseeable future.
Taking these factors into consideration, we think that interest rates are likely to remain moderate for some time.
According to Bloomberg Markets, the bond market has experienced remarkably steady performance over the last 75+ years. From 1940 through 2017, the Barclays Aggregate Bond Index (AGG), a widely recognized index of bond market activity, has only experienced 10 calendar years of negative returns. The worst of those years was a negative 3.2% return in 1969. However, the following year (1970) saw the index up nearly 17%. In fact, in every case but two, the down years were followed by positive returns in the next year that exceeded the previous losses.
What could an unexpected spike in rates do to the value of bonds? As an example, witness the historic interest rate spike of 1980. In that period, the prime lending rate rose from 11% in July to a record high of 21.5% in December2. While the overall bond market did suffer a loss of 7.3% in early 19814, the rebound was significant. By year-end the AGG had recovered to provide a positive return for the year of 6.26%4. Even more interesting is that the following year (1982), the AGG returned an impressive 32.65%4, outperforming stocks by over 11%.
In addition, bonds continue to provide that hedge against negative stock market volatility. During the financial crisis, stocks (as measured by the performance of the S&P 500 Index), showed a negative return of approximately 37%. Meanwhile, the AGG provided a positive return of 5.24%4.
Some investors’ fears of higher rates negatively impacting bond values may be exaggerated. Our recommendation is to stay the course. Maintaining a prudent allocation to bonds has been, and continues to be, an important part of a properly allocated portfolio. History shows that negative volatility in bonds can be a fraction of potential equity market erosion. In the event of a stock market correction, a prudent allocation to bonds will provide a portfolio hedge, mitigating equity market risk and stabilizing returns.
History also demonstrates that higher interest rates alone do not diminish the importance of bonds in a portfolio. In fact, bonds show remarkable resilience in volatile times, and even in times of rising interest rates.
Of course, if you have any questions or concerns, please feel free to contact your Atlas Wealth Management Advisor to discuss your specific situation with you.