Negative Returns Ain't Much of a Living

What does this clip from the classic western “Outlaw Josey Wales” have to do with investing in bonds?

 

Rather than trying to pull off a voice-over parody that begins with line, "Are you a bond investor?" I thought it would be more instructive (and more within my technical skillset) to relay an analogous real-life conversation I had with a client who posed the following question...

"I would like to earn a better rate than 0% on my cash. How much risk is there in bond ETFs?”

He then offered up four examples of ETFs that are currently generating distribution yields of 1-2% by investing in underlying portfolios of U.S. government guaranteed bonds including traditional treasury bills, notes, and bonds and treasury inflation protected securities (TIPS).

For the record, I am fielding similar questions from clients pretty much every week. Out of the approximately $270 million of client assets I oversee, more than $50 million currently resides in FDIC-insured cash paying virtually nothing. Most of this money accumulated from CDs and treasuries that matured in the last two years and have not been reinvested because renewal rates of .5% or less on 1-3 year maturities seemed to be too little to justify tying up. Extending maturities further is even less appealing. As of this writing, the 10-year treasury bond offers a 1.18% yield. The 30-year treasury sits at 1.93%. Still, as the gentleman who posed the question to me articulated, to many yield-starved consumers – most especially income-craving retirees - these 1-2% yields actually seem appealing.

Investing in U.S. Government Guaranteed Treasuries – What Could Possibly Go Wrong?

What these yields do not convey is the principal risk that goes along with investing in these bonds. While there is virtually no default risk from investing in U.S. government guaranteed bonds, the market value of all bonds fluctuates with changes in interest rates. What my client astutely wanted to know is what will happen to the value of these bond ETFs if, for example, rising inflation over the next several years causes investors to demand higher interest rates on new bonds. One way to answer that question is to look at the historical returns from bonds. The table below shows the total return (interest earned + price appreciation/depreciation) on various government bond indices over the past decade.

Table 1 U.S. Long Term Treasury Index (Source: Vanguard)

2020	2019	2018	2017	2016	2015	2014	2013	2012	2011
17.7%	14.83%	-1.84%	8.56%	1.42%	-1.17%	24.69%	-12.49%	3.77%	29.17%

YTD Return through 6/30/2021 = -5.18%

Table 2. U.S. Treasury Inflation Protected Securities Index (Source: Vanguard)

2020	2019	2018	2017	2016	2015	2014	2013	2012	2011
10.99%	8.43%	-1.26%	3.01%	4.68%	-1.44%	3.64%	-8.61%	6.98%	13.56%

YTD Return through 6/30/2021 = 1.61%

Table 3. U.S. Short-Term Treasury Index (Source: Vanguard)

2020	2019	2018	2017	2016	2015	2014	2013	2012	2011
3.16%	3.59%	1.56%	.45%	.87%	.57%	.64%	.37%	.50%	1.56%

YTD Return through 6/30/2021 = -.09%

So what can we glean from this data? First, as we can see from the highlighted boxes, it is possible for investors in treasuries, including TIPS, to lose money. Although interest rates have been generally falling for more than 40 years, the rate decline has not been uninterrupted. Each of the negative return years for the two longer term bond indices occurred during brief periods in which interest rates rebounded. The largest increase over this period of time saw 30-year treasury rates rise from a low of 3.1% in January 2013 to just under 4% by the year end. That mere 1% rise was enough to cause the 12.59% decline in the long-term treasury index and the 8.61% decline in the TIPS index.

Bond Returns from the Past Decade are Not Repeatable

Nonetheless, some investors may look at these tables and conclude that that there are far more and far stronger positive return years than negative ones and that such short-term risk is worth a little volatility. Here’s the problem with that logic – THESE RETURNS ARE NOT REPEATABLE! All of the positive returns in the table above were generated in large part by falling interest rates. As of this writing, treasury yields are at or very near historic lows. With the 180 day t-bill yielding .06%, and, as mentioned above, the 10-year and 30 year treasuries sitting at 1.88% and 1.93% respectively, in is inconceivable that rates can much lower. It is, however, relatively easy to envision a scenario in which even modest inflationary pressure (perhaps caused by trillions of dollars of government spending) pushes rates considerably higher. Given the magnitude of the negative returns in the long-term bond indices in the face of a just a 1% rise in rates, investors should think long and hard about whether reaching for 1-2% interest rate is worth the very real possibility of double-digit declines in value that may not be recouped for many years.

But what about short-duration bond funds? As per table 3, we see that even in 2013, the fund eked out a small positive return. While it is true that we expect less volatility with bond funds and ETFs that invest in bonds with shorter maturities, with current yields on short term treasury securities at less than .25%, even these funds may be expected to experience negative total returns if rates rise as little as 1-2% in any given year.

Summary

In sum, the purpose of this essay has been to raise awareness that we are at a unique time in the modern era of investing. Following 40 years of generally declining interest rates, rates are now at historic lows and have little room to fall further. In this environment, the best investors in traditional bonds funds and ETFs can hope for is for rates to continue to stay low. If inflation forces interest rates higher, investors face the very real risk of negative returns from this traditionally “conservative” portion of their portfolios. If rates rise sharply (e.g., 3-4% over a year or two), investors in funds and ETFs that hold intermediate to long term bonds may even experience negative returns on par with the volatility normally expected for bear markets in stocks.

In conclusion, if I were to produce a voice-over parody of the iconic gunslinger showdown from Outlaw Josey Wales, here is how the script would read:

Josey Wales (me): Are you a bond investor?

Bounty Hunter (FPH client): A man’s gotta earn a little interest to make a living somewhere these days.

Josey Wales (me): Earning negative returns ain’t much of a living.

Related Reading:

Investors see a risk tha the bond market has got it dead wrong about inflation (Marketwatch)

The Baby Boomer Bond Dilemma (NY Times)

John H. Robinson is the founder of Financial Planning Hawaii and a co-founder of financial advisor software-maker Nest Egg Guru.

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Securities offered through J.W. Cole Financial, Inc. (JWC) member FINRA/SIPC. Advisory services offered through Financial Planning Hawaii and J.W. Cole Advisors, Inc. (JWCA). Financial Planning Hawaii and JWC/JWCA are unaffiliated entities. 

Fee-only financial planning services are provided through Financial Planning Hawaii, Inc, a separate Registered Investment Advisory firm. Financial Planning Hawaii does not take custody of client assets nor do its advisers take discretionary authority over client accounts. 

The information contained herein is general in nature. Neither Financial Planning Hawaii nor J.W. Cole provides client-specific tax or legal advice. All readers should consult with their tax and/or legal advisors for such guidance in advance of making investment or financial planning decisions with tax or legal implications.