- Fears of the impact of rising rates on the total returns of bonds may be overblown.
- Volatility in other asset classes outside of fixed income should continue to be the primary concern for most target-date investors nearing retirement.
- Current valuations are not particularly favorable for either U.S. stocks or bonds, but equity valuations look far less promising.
Many investors believe we are destined for a prolonged period of rising interest rates. Understandably, this has led some to ask: “Is it still an appropriate time to own bonds?”
To help answer this question, we explored the long-term investment case for stocks and bonds.
In this post — the second of a three-part series — we examine the question: “Are bonds too risky right now?”
In our analysis, we took a critical look at the historical experience of the early 1960s through the early 1980s, along with current stock and bond valuations, to glean possible insights for investors today.
A common view among the investing public is that bonds are simply too risky to own in the current market environment.
The focus is on two main points:
- We will be entering a prolonged period of rising interest rates
- Inflation will continue to remain elevated
For simplicity, we can set aside reasons to expect interest rates and inflation will moderate, and subscribe to the view that they will be persistent problems or even worsen. Using this scenario, we should then try to ascertain what the potential impacts could be on bonds and stocks.
For that, history can be a useful guide. In fact, many investors have already looked to the prolonged period of rising rates and elevated inflation experienced in the 1960s and 1970s as a precedent. During this period, U.S. 10-year Treasury yields advanced from roughly 4% to 14% and inflation, as measured by year-over-year Consumer Price Index, rose from around 1% to a peak of approximately 15%.
Charts 1 and 2 look at the historical U.S. 10-year Treasury yield and year-over-year changes in CPI.
Historical U.S. 10-year yield and year-over-year changes in CPI
Sources: U.S. Treasury, Bureau of Labor Statistics.
Returns from December 1961—December 1981
The table below shows returns of bonds, stocks, and two blended portfolios (50% stocks/50% bonds and 25% stocks/75% bonds). Stocks are represented by the Ibbotson U.S. Large Stock TR Index and bonds are represented by the Ibbotson U.S. Intermediate Term Government TR Index.
Notice that bonds lag stocks by only 1.6% on an annualized basis in nominal returns. Notably, the performance differential during this period is much narrower than for the full history, in which stocks outperformed bonds by over 5% over the near 100-year period studied in our prior post. This small margin of underperformance combined with much lower volatility (one measure of risk) gives bonds much higher risk-adjusted returns versus stocks. Additionally, we observe that a 25% stock/75% bond blend has the highest return relative to its risk (0.94).
Chart 3 illustrates performance with cumulative growth for the selected asset classes and portfolios. Importantly, even though U.S. 10-year Treasury yields rose from roughly 4% to 14% over this period, bonds still delivered positive, mid-single-digit returns.
Historical risk/return metrics (1962–1981)
Sources: Morninstar, Putnam.
Chart 3: Cumulative growth (1962–1981)
Sources: Morningstar, Putnam.
Drawdowns as a measure of risk
Instead of looking at volatility, another way to measure risk is to look at the maximum drawdown of a specific time period. Chart 4 looks at rolling maximum drawdowns over the 1962–1981 period (using monthly data). Additionally, we highlight the eight largest unique drawdowns in chart 5.
The main takeaway: Stocks experienced several significant drawdowns of over 20%, while bonds experienced only two meaningful drawdowns in the late 1970s and early 1980s of 8%–9%.
While there has been significant attention paid to the drawdown experienced by bonds in 2022, retirement investors should maintain a broad perspective. Even in a period of rising interest rates, stock market drawdowns occurred both more frequently and in greater magnitude, posing a far more significant challenge to investors planning to retire in the near term.
Sources: Morningstar, Putnam.
Investors who believe equities are more attractive than bonds today should compare current valuations with the 1962–1982 period. As of June 30, 2022, the Shiller CAPE ratio for the S&P 500 Index stands at 29.53, which is in the 94th percentile relative to its history. For much of the 1962–1981 period, the Shiller CAPE Ratio was in the 10x to 25x range.
In contrast, the bond risk premium, as measured by the difference between the U.S. 10-year Treasury note yield and the yield on 3-Month Treasury bills, is much closer to its historical median, at the 49th percentile. This is noteworthy because there has historically been a strong relationship between bond risk premium and forward returns.
Investors calling for a longer-term reduction to bond allocations while reallocating toward equities because of the current market environment may be disappointed if history is any guide. In fact, one could argue that given equity valuations today, conditions may be even less attractive for stocks than in past episodes of rising rates and elevated inflation.
Though we recognize some of the challenges facing duration-sensitive bonds today, we encourage retirement savers to maintain perspective when choosing the best asset allocation for their current situation. With historical context in mind, we would argue that the fear surrounding rising rates and their impact on retirement savers’ portfolios is likely overblown. Furthermore, retirement-altering drawdowns will still most likely be driven by non-fixed income investments.
Next in the series
In our final post of the series, we discuss the ways target-date managers can mitigate rate risk in the construction and implementation of their portfolios amid today’s increasingly uncertain market environment.
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