What Is Unusual About These Markets?

What has been challenging is that we have not been able to rebalance our stock portfolio with bonds that are up. Typically, we go shopping when stocks fall, as we normally have Treasury bonds providing the capital to do so. Recently, we saw very tangible benefits of this during the first half of 2020. This diversification, however, works over longer timeframes, and not always in the short-term, like the first half of this year.

At Forum, we focus on what we know: capital markets deliver in the long run. One helpful example of this is to reflect on stock market performances after recent declines, as the chart below indicates.

Most clients have not been unusually concerned by the stock market losses this year – after all, 20% losses from previous market highs happen with a very high degree of regularity, so much so that we build our trading protocols to rebalance roughly around 20% asset class bands. Since 1980, the S&P 500 index was down 20% or more from its prior high approximately 1 out of every 5 years. Stock investors should be somewhat acclimated to this kind of volatility.

As the chart below indicates, the start to this year has been very unusual for bonds. The point that we made in our prior article, however, remains valid, which is that while we can confidently say short-term interest rates will be going up, we do not expect long-term rates to necessarily rise from here, and they could even fall if the Federal Reserve does a good job addressing inflation expectations.

What the chart above does not say is that we are entering into a period like the 1980s. In fact, if you look at inflation protected bonds, the inflation in the second half of this decade is expected to be around 2% to 3%. The chart above simply shows that rates across bonds have risen more rapidly than at any time in the past. They may have already risen to where they need to be to reach equilibrium. Do they have further to go? Might they fall back down? It all depends on future investor expectations: do they perceive global risks being higher or lower from here? Right now, whether it is the risk of war, or supply chain issues or everything else, that perceived risk is high. If some of these global risks resolve themselves, intermediate bond rates could come back down even if the Fed continues to hike short-term rates.

Rising interest rates, which are the primary cause of recent bond price drops, are actually a good thing for most long-term investors, especially for retirees.

Let us use an example with 10-Year Treasury Bonds to understand why higher yields are usually a good thing for long-term investors from a wealth perspective. From the beginning of the year, a 10-Year Treasury Bond lost 15.2% as of June 15, but each future interest payment received gets reinvested at the new higher rates, producing an expected 18.1% over the next 10 years. An investor expects to be 2.9% wealthier by the maturity date than if rates had not increased. We have detailed the bond math below for those in the audience who enjoy digging into that.

Retirees especially benefit because higher yields allow retirees to sustainably draw more from their portfolio. Many individuals have heard of the 4% rule of thumb (that a retiree can sustainably withdraw up to 4% of their portfolio without risking running out of money). For most of the 2010s, the concern for retirees was that withdrawing 4% of the portfolio was too high of an expectation because of how low bond yields were. This year’s moves make 4% a much more reasonable expectation going forward.

In short, we should continue to position the portfolio to have the greatest odds of success looking ahead. Long-term, stocks and bonds are the two asset classes that have positive real returns, returns above and beyond the cost of inflation. 3 out of 10 years in diversified portfolios we have seen, and we expect to see, negative returns. And in 3 out of 100 years we may see large (greater than 5%) negative returns in both stocks and bonds. Without that risk, there would be no return. Our perspective is that we need to stay disciplined, not assume these outliers have become a new normal, and take advantage of the lower prices. Your future self will thank you for staying invested in a diversified way.

Note on 10 YR Bond Math: 10-year Treasury Bonds entered the year with a yield of 1.52%, meaning if an investor bought $100 of a bond, it would pay you $1.52 for 10 years, and then the investor would receive their $100 back at the end of 2031. As of 6/15/2022, 10-year Treasury Bonds yield 3.33%, causing the price of the bond in our example to drop from $100 to $84.80 or by 15.2%. Why? Because the coupon is only paying $1.52/year whereas newly issued bonds are paying $3.33, so to get a 3.33% yield on the old bond, the purchase price (or market price) must decline. As a long-term investor though, I am better off. How? Because now as I get paid $1.52/year, I can reinvest the coupons at 3.33%, when at the beginning of the year I might have only been able to reinvest at 1.52%. This additional yield of 1.81% over 10 years is an additional 18.1% in wealth, but I only lost 15.2% on the current price of my bond. So, over the next 10 years I end up overall 18.1%-15.2% = 2.9% wealthier. This is true whether I hold a single bond or an aggregate of bonds (in a bond fund as long as the bond fund is consistent in its approach and holdings).