High quality bonds are currently a decent investment, but rising interest rates in the future could make them a risky part of your portfolio.
High quality bond (e.g. U.S. Treasuries…) interest rates are currently awful from a historical perspective; however, based on low or non-existent inflation, some of these bonds are currently a decent value. You have to view the value of bonds relative to current inflation/deflation. In the current deflationary environment – with a significantly overvalued stock market and the difficult economic environment – U.S. Treasury bonds are actually a decent investment to hold in a portfolio. A U.S. 10 year Treasury bond yielding 1.72% is a bargain versus a Japanese 10 year bond at -0.083% (yes that is negative!) or a German bond at 0.100%.
In the future – after we start to pull ourselves out of this mess and interest rates are actually rising – these high quality bonds will be a very risky investment that will lose money. You may ask why? Isn’t it always wise to hold high quality bonds? Nope! The perversion of interest rates by Central Banks across the globe has forced investors (and the Banks) to bid up the prices on these bonds to nosebleed levels. There is a negative long term impact as a result of these policies. If the interest rate yield on 10 Year U.S. Treasury bonds increases by 2%, the value of existing Treasury bonds will most likely plummet approximately 20%. This 2% increase would only bring the interest rate to 3.72%, which is low by historical standards. Since 1962 the average interest rate yield on the 10 Year U.S. Treasury has been 6.37%. If you exclude the high interest rate period in the 1980’s and the low interest rate period of the last several years, the average interest rate was approximately 5.7%. If 10 Year U.S. Treasury bond interest rates moved from today’s level of 1.72% to the historic average of approximately 6%, the value of the bonds you currently hold would probably drop by approximately 40%!
However, don’t panic and sell your high quality bonds anytime soon.
It could take a long time for interest rates to rise. If you use Japan as a guide, we could be in this low interest rate environment for a long time. We are following Japan’s failed over-manipulation of interest rates playbook (Ben Bernanke wrote this playbook for them). We have a similar (not as bad, but similar) aging demographic and a deflationary economic environment. The bond experts Hoisington Management showed that after previous economic crises it took on average approximately 15 years for interest rates to bottom. Japan is defying that average where their economic crisis started in 1989.
I hope that the Federal Reserve and other central banks across the globe smarten up soon and resist further manipulation.
