Image Credit: Christophe Vorlet
By Jason Zweig | July 15, 2016 9:19 am ET
With bonds producing near-record-low levels of income worldwide, there’s never been a worse time to invest in government and corporate debt. You earn next to nothing now and, if interest rates finally rise, you will get clobbered later.
That’s the conventional wisdom, and it’s wrong.
With 10-year U.S. Treasury securities yielding just under 1.6%, a $10,000 investment produces a paltry $158 in annual interest income. But, properly measured, the returns on bonds are higher than they have often been in the past. And, for many bond investors, rising rates will turn out to be a blessing, not a curse. Finally, even if yields go lower from here, bonds will still provide valuable insurance against losses in the rest of your portfolio.
With bonds, as with all investments, what counts isn’t how much you earn but how much you keep. That 1.5% return on the 10-year Treasury is nominal — literally, “in name only” — because it doesn’t account for how inflation erodes the purchasing power of your interest income over time. By subtracting any increases in the Consumer Price Index from the nominal yield, you arrive at what’s called the real yield — how much income you keep after inflation.
With the CPI up at a 1% annual rate, you are earning a real yield of 0.5%.
You shouldn’t jump for joy at that. But don’t let anybody tell you the return on bonds is so much lower than in the past that they aren’t worth owning at all anymore.
Let’s think back to 2011, when nominal 10-year Treasury yields were just under 2.8% — nearly double today’s rate. But inflation ran at 3% in 2011, so the real yield was negative. U.S. bonds have had negative real yields in almost one out of six years since 1800, according to Harvard University economist Carmen Reinhart.
Why, then, do so many bond investors feel nostalgic for the days when yields were negative after inflation, while they feel cheated by today’s marginally positive real income?
Blame the “money illusion.”
The term was coined by Irving Fisher, an economist at Yale University, in his 1928 book of the same name. Fisher defined it as “the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value.”
In the money illusion, nominal figures jump out more vividly than real numbers.
Would you rather receive a 2% yearly raise when inflation is running at 4% annually, or a 2% pay cut when inflation is nonexistent? Either way, you keep only 98 cents on the dollar after adjusting for its purchasing power. But the 2% raise, even though it is less than the increase in the cost of living, makes you feel better; that nominal gain distracts you from the real loss.
A nominal pay cut feels like a direct insult or injury, while calculating the real rate takes an extra mental step.
In a classic experiment, people were asked who would be happier: someone who got a 2% yearly raise when inflation was zero or someone who got a 5% raise when inflation was 4%.
In real terms, the first person is 2% better off, while the second earns only 1% more than before. Nevertheless, two-thirds of those surveyed said the person with the 5% raise would be happier and less likely to accept a job offer from a competing firm.
The 5% is simply a bigger number than the 2%. So it feels like a greater reward, even though inflation eats up more of it.
Bear that in mind when you find yourself pining for the good old days of higher bond yields. Many of those days were worse than today.
And what if interest rates rise?
The Barclays U.S. Aggregate Bond Index, a measure of the fixed-income market, would immediately go down in price by about 5.5% for each one-percentage-point rise in rates.
But when rates rise, you can reinvest your income steadily over time in new bonds with higher yields. So long as inflation remains moderate, the ability to reinvest at newly higher rates will ultimately raise your yield, not lower it.
Still, many long-term bonds would lose 20% or more in only a one-point rate rise. “Investors should be prepared for increased volatility and greater losses than they’re accustomed to,” says Gemma Wright-Casparius, a fixed-income portfolio manager at Vanguard Group. “People think they’re immune from that, but they’re not.”
Fortunately, only about 6% of the $85 billion that has flowed into taxable-bond funds this year has gone into long-term portfolios, estimates the research firm Morningstar. Such risky funds are only for folks who find roller coasters relaxing.
The generation-long bull market in bonds is probably drawing to a close. But high-quality bonds are still the safest way to counteract the risk of holding stocks, as this year’s returns for both assets have shown. Even at today’s emaciated yields, bonds are still worth owning.
Source: The Wall Street Journal, http://on.wsj.com/29IVH63
For further reading:
Definitions of BOND, FIXED INCOME, INFLATION, YIELD in The Devil’s Financial Dictionary
Chapter Two, “The Investor and Inflation,” and Chapter Four, “General Portfolio Policy: The Defensive Investor,” in The Intelligent Investor
Eldar Shafir et al., “Money Illusion” (Quarterly Journal of Economics, 1997)
Bernd Weber et al., “The Medial Prefrontal Cortex Exhibits Money Illusion” (Proceedings of the National Academy of Sciences, 2009)