The investment industry has long recommended that investors build a balanced portfolio of stocks and bonds for their retirement nest egg. A typical portfolio may be 60% stocks and 40% bonds depending on the investor’s age and risk tolerance. History suggests that bonds will reduce the portfolio risk and provide a steady income for retirees. But, today, bond yields are nowhere near their historical average.
According to JP Morgan, the average yield of the ten-year US Treasury bond has been 5.9% since 1958. Inflation over that period has averaged 3.6%, lower than the latest core reading of 4.5% for the last twelve months through June. Today, though, investors aren’t getting the historical yield of 2.2% over the rate of inflation. With current yields at 1.4%, they are getting 3.1% less than inflation. That’s about 80% less than the historical yield! Even if inflation falls back to around 2%, today’s yields still produce a negative real (inflation adjusted) return, even before taxes.
The stock market is wildly unpredictable, impacted by a wide variety of variables, but bonds are very simple, especially bonds backed by the US Treasury with little risk of default. If you buy a Treasury bond today that matures in ten years, the yield is about 1.4%. You’ll get that interest every year and the return of your principal at maturity. No more, no less. But, if you don’t hold the bond for the full ten years, the price can vary significantly.
Let’s look at some bond math in simple terms. Say you buy a $10,000 Treasury bond today and get the 1.4% yield. You’ll earn $140 each year for ten years for a total gain of $1,400. But let’s assume rates move back to their historical average yield of 5.9% a year from now. Investors that buy those bonds would earn $5,900 over the next ten years while your bond will still be paying the very low yield that you locked in when you bought it. You could sell your bond but who would buy it? A potential buyer would be giving up $450 every year in interest ($590-$140) for the next nine years. That’s over $4,000. If they could buy it from you for about $6,000 then they may break even when the bond matures at $10,000. In other words, if interest rates rise to their historical average, the price of your bond would drop by about 40%!
When we look at different types of investments, we look at the risk/return trade off. Today, the ten-year US Treasury bond yields just 1.4% and higher quality corporate bonds yield about 1.8%. That’s the upside. The downside is a potential price drop of 40% if rates revert to their historical averages and even more if rates were to go higher than that.
Investors who think that bonds like treasuries, highly rated corporates, and municipals are somehow safe today may be in for an expensive lesson in bond math and history. And, if your financial advisor is still proclaiming the benefits of a 60/40 portfolio, maybe it’s time to find a new advisor. If your portfolio, including your retirement plan assets, totals at least $500,000, we’d be happy to talk. Contact us or schedule a meeting or call today.