Do bonds have a place anymore in your portfolio in the new Federal Reserve paradigm?
The Fed has a long history of creating asset bubbles, then later – sometimes years later – letting the air out of the balloon through monetary policy or regulatory change, leaving investors licking their wounds.
The most recent and most dramatic bubble inflation and subsequent deflation, of course, occurred in the first decade of this millennium. Through a policy of low-interest rates, the Fed largely encouraged American consumers to borrow heavily against their homes, while its laissez-faire regulation of the banks it’s supposed to monitor allowed these same consumers to borrow whether or not they had the wherewithal to pay the loans back.
We all know what happened when the Fed suddenly reversed course and raised interest rates and, perhaps more importantly, required banks to make their customers actually prove that they were good credit risks (imagine that?). We’re still feeling the fallout more than 10 years later, as millions of people defaulted on their loans because they couldn’t borrow any more money.
Now we have a similar story, only with stocks and bonds, but the Fed has taken a different attitude. It’s showing no inclination to prick the bubble it has created in financial assets through historically low-interest rates for a historically long period of time and through quantitative easing, i.e., attempting to corner the market on U.S. Treasury and mortgage-backed securities basically.
Yields on long-term government securities are now at their all-time lows, mortgage rates are at or near their all-time lows, while stocks are near their all-time highs even after this week’s coronavirus-inspired panic selloff. Yet the Fed has not responded as it has in the past, by letting some air out of the bubble, for the simple reason, it has said repeatedly because it doesn’t believe there is an asset bubble. Nor will it start to normalize monetary policy or start paring back its gargantuan balance sheet even though it insists, repeatedly, that the U.S. economy is “strong.”
Instead, the Fed always finds a reason not to tighten policy. Right now, that excuse is the uncertainty about the global and domestic economic effects of the virus. A few months ago, it went back to easing policy – following a short-lived tightening that met with near-universal howls of pain from Wall Street – as “insurance” against a possible U.S. recession, even though there was little evidence that one was in the offing. Before that, the Fed had myriad excuses to avoid tightening policy, everything from Brexit to trade wars to government shutdowns. Wanna bet climate change is next? It’s already on the Fed’s radar screen as a regulatory matter; don’t be surprised if it includes it in its monetary policy equation soon.
Given this scenario, with interest rates so low and no sign of going higher, do bonds have a place in your portfolio?
If I’m right, and the Fed will never tighten policy as it has in the past, long-term bonds won’t provide much of a return. As I write this, the 10-year Treasury note was yielding less than 1.40%, while the 30-year bond was closing in on 1.80%. By contrast, the yield on the stocks in the S&P 500 were yielding well above that, while plenty of good quality stocks were yielding 3% or more. Lots of equity ETFs and mutual funds also pay hefty dividends, well above Treasury yields.
If I’m wrong, and the Fed eventually does revert to its historic form and allows rates to rise, bond yields will soon skyrocket while prices will crater. Stock prices might, too, but at least you’ll have that high dividend rate to soften the blow. But the chances of this happening, compared to the first scenario, are pretty slim.
Unsophisticated investors are told all the time that bonds, especially U.S. Treasuries, are one of the safest investments around. After all, as they teach you in graduate business school, the yield on Treasuries is the “risk-free” rate because we can rest assured that the U.S. government will never default on its debt obligations.
That may be so, but investors are rarely told that bonds carry other risks, namely price risk, just like stocks do. But for my money, I feel more comfortable taking a risk on quality dividend stocks than on Treasuries. You get a higher yield and the prospect of unlimited price appreciation. With bonds already yielding well under 2%, how much more price appreciation can you expect?
So that’s what bonds offer today: historic low yields, and the chance of substantial price depreciation. That’s not a bet worth taking.
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INO.com Contributor - Fed & Interest Rates
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.