The Bond Story

The Bond Story

Over the years it has been generally believed that a 60/40% stock to bond allocation made sense, particularly for conservative investors and people approaching retirement age.  The notion is that given one’s long-term goals, a reasonable return could be achieved on both stocks and bonds so as to meet life-style objectives.

The approach worked well for some time given the bond yields available in the 1970s, 1980s, 1990s and even into the 2000s until the financial meltdown of 2008.  The financial crisis of that time and the Gepression induced by the pandemic (2020) has changed the financial market construct.

The zero (0) short-term interest rates in the early years after the financial crisis with quantitative easing (I, II, III, etc.) kept downward pressure on bond rates.  Subsequently, the Federal Reserve’s attempt to move rates up to what it thought was the neutral (natural) interest rate did not succeed.  Its 2% inflation target was never achieved as iys forecasting failed to capture the structural changes in the economy.  The rise in rates into 2018 gave way to major rate reductions in 2019 and early 2020.  Again, the inflation target was not attained.  The pandemic and the government’s response moved us further back to zero (0) interest rates and a massive (unprecedented) degree of monetary accommodation.  The 10-year Treasury recently hit a record low and now sits at 0.65%, hardly a yield that can generate a return suitable for meeting retirement objectives.  Recently, a new issue of a 10-year junk bond hit a record low of 2.85%.  Mortgage rates below 3% are good for the borrower, but not so for the lender.

The financial crisis in 2008 and the pandemic Gepression twelve years later has significantly altered the economic and financial market structure on a worldwide basis.  New tools and ideas are being employed in response to these crises.  As with The Great Depression, the changes in the aftermath of catastrophic events altered the face of the economic and financial system.  Financial reforms and public policy changes played critical roles. These recent crises and the structural changes they produced (accelerating technological innovation) has taken public policy to a new level.  The Federal Reserve is going through a total review of its models, mechanisms, and the methods to communicate policy.  The weakness and deficiencies evident in the last 10 years have prompted this reexamination.  Real time data, as opposed to forecasts, are likely to foster policy changes.  Consequently, particularly as it relates to inflation, tolerating higher inflation rates are likely in order to meet the symmetrical inflation goal.  The rate target may even be raised.  With unemployment at current elevated levels and the minority rate even sharply higher, an extended runway for “very easy” monetary policy makes the most sense.  A rethinking of the full employment goal is probably also in order.

We are in a disfigured world economy.  Restricted activity is abound, supply change disruptions still persist, negative interest rates are prevalent in many parts of the globe, and the flu season and the pandemic could collide, adding more confusion.  However, the prospects of a vaccine have improved significantly.  Protocol now exists for treating COVID-19 and many companies have been remarkably creative in adjusting to the new environment.  The second quarter earnings reports have been far better for many companies than analysts expected.  The e-commerce component of their businesses has exploded (witness: Target, Walmart, Home Depot, Lowes, etc.).

The ISM surveys by Markit are showing the U.S. economy is expanding and recovering from the Gepression, but parts of the economy most directly affected by the pandemic (entertainment, restaurants, air travel, etc.) continue to struggle.

The bifurcated economy and the level of unemployment will continue to weigh heavily on policy makers.  A fiscal stimulus plan is likely in the coming weeks and the Federal Reserve has committed itself to an outlook that only fosters greater accommodation.  Expect additional monetary steps.

This kind of environment only makes bonds unattractive as an investment vehicle attempting to achieve a reasonable long-term return.  The return is virtually non-existent and likely to be so for some time, and the risk to the corpus is increasing as the economy recovers.  Although more volatile, a greater weight to equities increases the chances of achieving a reasonable long-term return to meet most investment goals. Otherwise, expected returns should be lowered with the traditional bond allocation.