Should You Be Concerned About Bonds In Your Portfolio?
For the second time in three years, J.P. Morgan CEO Jamie Dimon says he would not buy bonds.
The first was in August 2017, when he said he would not buy any sovereign government debt. The second time (December 8th, 2020), Dimon limited his critique to U.S. Treasury bonds, specifically the 10-year treasury, saying, “I think Treasurys at these rates, I wouldn’t touch them with a 10-foot pole.”
You would think that the CEO of the largest U.S. bank has a good grip on the direction of interest rates. Because rising rates can make for a poor environment for bonds, he must be thinking that interest rates will increase.
How Did He Do Last Time?
His 2017 recommendation turned out to be early or just flat-out wrong. The iShares U.S. Aggregate Bond Index, a proxy for the U.S. bond market, averaged a little over 5% per year from 2018 to 2020. It was up 8.5% in 2019 and 7.6% in 2020, and down just 0.13% in 2018. That’s hardly an investment not worthy of touching with a 10-foot pole.
How about his latest prediction? Well, because of COVID-19 and the Federal Reserve’s \$3 trillion of additional quantitative easing (Q.E.), interest rates are lower than in 2017.
In 2017, the 10-year treasury yielded 2.05%. Today, it is yielding 1.04%, or almost a 50% drop in yield. (It got as low as 0.59% in July 2020.) That drop allowed a bond paying only, say, 2% in interest to return 7%. Remember, when interest rates fall, bond prices go up. The reverse also happens, meaning when interest rates rise, bond prices fall.
What Causes Treasury Rates to Rise?
The federal government ran a deficit of \$3.1 trillion in 2020. If passed, President Biden’s $1.9 trillion COVID-19 relief proposal will pay for much of itself with bond sales. With all this debt supply, you would think that if demand does not increase, then interest rates would have to rise.
However, much of the debt is being purchased by the government’s bank, the Federal Reserve. These purchases, through quantitative easing, allow increasing debt without a corresponding increase in interest rates. We will see what the long-term implications are of the government’s bank owning significant amounts of the government’s debt.
Rising Inflation Effect on Bonds
The other thing that could happen is that inflation begins rising, and investors holding bonds paying 1% will not look so good if the cost of living increases to 3%. That discrepancy causes rates on new bond sales to rise as no investor wants to own a bond paying less interest than the cost of living, i.e., inflation.
Nobody knows what causes inflation to rise. Monetarists represented by Milton Friedman believed that increasing the money supply causes it. However, since the late 1970s—the last time inflation was terrible—the money supply has been rising, but inflation and interest rates have been falling.
Labor vs. Capital
Since the late ’70s, more of the economic pie has gone to capital, resulting in rising stock prices and falling bond yields. If labor somehow wrestles some of that pie, then the costs of goods and services (inflation) might start growing while the bubble gets let out of the stock and bond markets.
Should You Still Own Bonds?
Bonds are essential in a portfolio, so unless an investor’s risk tolerance or goals change, it is unwise to scrap or reduce their portfolio’s percentage invested in bonds. Suppose in the future, inflation does spike. In that case, investors with diversified portfolios can implement fallback strategies: adding shorter-term bonds, inflation-protected bonds, or emerging market bonds (asset allocation and diversification strategies cannot assure a profit).
Read More: The Risk of Quantitative Tightening
Remember, the asset managers and pension plans that sold bonds to the Fed used those proceeds to purchase risk assets. Those purchases propelled those assets higher, and higher prices enticed speculators who borrowed money to buy those same risk assets. The public, frustrated by the low interest rates, also purchased those risk assets. So, in addition to excess reserves, the other side effect of Q.E. is that risk assets, such as stocks, get expensive.
These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice.