August 20, 2015
August 20, 2015
The recent trend of lower returns is not unusual – we know from history that disciplined long-term investors have been rewarded with attractive returns but that the timing of these returns has been quite uneven. Periods of high returns have been followed by periods of flat and negative returns. History also informs us that predicting the timing of the high-return years has been extremely difficult.
The uneven and unpredictable nature of short-term returns underscores the importance of discipline and patience for long-term investment success.
Undisciplined investors tend to chase yesterday’s best performers, increasing the likelihood they’ll miss out on gains when markets turn. Conversely, investors who can remain patient during the lower-return years are well-positioned to capture higher returns when markets turn upward and register stronger gains.
From an investor’s standpoint, the key long-term return consideration is the return after inflation, referred to as the “real return.” While recent portfolio returns have been lower than the long-term averages, inflation has also been quite low.
The benefit of low inflation for investors can be illustrated by considering the data for 2014. For the full year, inflation in the U.S. rose just 0.8%* from a year earlier. As a result, a portfolio that generated a 4% return earned a real return of 3.2%. This 3.2% real return is within range of the historical average real return generated by a 50% stock and 50% bond portfolio.
A major contributor to the recent lower portfolio returns has been low bond returns. Over the past three years through June 30th, short-to-intermediate-term, high-quality U.S. bonds generated annualized returns between 1% and 3%. Bond yields are up from their lows of several years ago but remain quite low by historical standards. The table below shows current U.S. Treasury yields (as of June 30th) and those from three years ago.
A review of this table and bond returns over the past three years leads to an important observation. Even though most interest rates have risen over the past three years, bond returns have been positive. The takeaway is that bonds, particularly shorter-term bonds, can generate positive returns in a rising interest rate environment as long as the rate increases are somewhat gradual and the investor focuses on a longer time horizon – in this case, three years. This longer time horizon provides sufficient time for the higher yields to offset the initial price declines caused by rising rates.
We’ve given much thought to the implications of low bond yields for investment strategy. In our view, the current yields on offer for longer-term bonds do not adequately compensate investors for the interest rate risk inherent in these securities. In response, we’ve shortened the average duration (a proxy for average maturity) of our clients’ U.S. bond portfolios to approximately three years – about half the duration of the overall U.S. high-quality, taxable bond market. We believe this three-year target strikes the appropriate balance between our preference for less interest rate risk and the goal of earning an incremental return over cash on the bond portion of the portfolio.
We have also considered many other potential “solutions” to the low bond yield situation. Most of the products advertised by Wall Street as bond substitutes are not substitutes at all. Instead, they are expensive products that carry additional, often hidden, risks. Although we have not yet identified any acceptable alternatives, we continue to search the landscape for investments that may help offset the impact of low bond yields.
As we search for acceptable bond substitutes, we will not likely be recommending high-yield (junk) bonds as a solution. In 2008, as the financial crisis worsened, we observed how liquidity dried up for junk bonds and prices plummeted.
If anything, the liquidity risks inherent in junk bonds are even greater today. In response to new regulatory requirements, the large investment banks that previously acted as market makers in junk bonds have dramatically reduced their willingness to own these bonds. It is hard to imagine who will buy them the next time the market encounters serious stress. Without buyers, sellers would be forced to accept severely discounted prices. Perhaps the Federal Reserve will step in to provide liquidity but this would likely happen only after much turmoil and losses to investors.
Members of the Federal Reserve, including the Chair, Janet Yellen, seem intent on beginning the process of raising short-term interest rates. The Fed funds rate has been stuck at 0% for more than six years now and Fed members are aware that these extraordinarily low rates can distort business and investment decisions. Our guess is that the Fed will begin raising rates over the next six months, but we expect any increases to be very gradual.
With a cautious Fed and low inflation, bond yields are likely to remain quite low in the near-term. In this low-yield environment, investors will need to continue drawing upon the discipline and patience that is essential for long-term investment success.
*Source: Federal Reserve Bank of St. Louis – Consumer Price Index for All Urban Consumers