Bonds: Can’t Live With Them, but How Do You Live Without Them?
Bonds: Can’t live with them, but how do you live without them?
Quick look
- We find today’s bond market exhibits more risk and less reward than in past decades.
- In the early 1980s, the 10-year Treasury bond offered nearly eight times the yield it does today with less than two-thirds of today’s sensitivity to interest rates.1
- The annualized total return of the Barclays US Treasury Bellwethers 10-year Index from September 1981 through May 2015 was 8.5%.1
- Today’s low starting yields will make it difficult for bond investors to earn the same returns they did in past decades.
Then and now
For generations of investors, conventional wisdom regarding managing portfolio risk relied on the cardinal rule of diversification. In its simplest form, this meant holding high quality bonds in an attempt to generate income, and offset volatility and drawdowns in the stock market.
This approach served investors reasonably well for many years. During the decades leading up to the financial crisis, bonds offered a valuable means of investment diversification and returns, as historically high interest rates moved gradually lower.
Today, the risk/reward profile of the bond market looks dramatically different. Bond yields are at historic lows, while duration (or interest-rate risk) is significantly higher.1
10-YEAR TREASURY YIELD TO MATURITY
The chart above illustrates the historical yield to maturity of a 10-year U.S. Treasury Bond and is shown for informational purposes only. Past performance is no guarantee of future results.
So what are the implications for investors? As indicated in Exhibit 2, bond market yields have generally been predictive of bond market returns. Given today’s low yields, this is not good news for bond investors.
To put this into context, consider the 8.5% annualized return that the 10-year Treasury bond has generated since September 1981. In order for a newly issued 2.0% 10-year Treasury bond to generate 8.5% over the next five years, its yield to maturity would have to fall from 2.0% to -5.2%.1
Negative yields are certainly possible, as seen recently throughout Europe. However, the likelihood of U.S. yields falling more than 7% seems low. In fact, interest rates seem more likely to move higher than lower. During the 10 years prior to the financial crisis, the yield on the 10-year Treasury averaged 4.8%. Since the end of 2008 it’s averaged just 2.6%.
With bonds now offering a much poorer risk/reward profile than in decades past, their appeal and usefulness as a risk diversifier is greatly diminished.
So where do advisors go from here?
The challenge of generating reliable income in a low-rate environment is causing many advisors to rethink traditional planning techniques (e.g., static stock/bond allocation). This includes using risk management tools that may not have been available when traditional planning methods were developed.
One such tool is the use of a risk management overlay on the equity markets in an effort to stabilize volatility and reduce downside risk. Similar risk management techniques have been used by major financial institutions to develop cost-effective safeguards in an effort to weather volatile markets.
This approach has created a new category within the investment industry referred to as “managed risk equities.”
Managed risk equity strategies often seek to stabilize the short-term volatility of a portfolio around a target level (e.g., 12% standard deviation), and reduce the downside exposure of a portfolio during periods of significant and sustained market decline. The managed risk fund space recently surpassed $260 billion in assets through various mutual funds, exchange-traded funds, collective investment trusts, target-date funds, and variable annuities.2
About Milliman Financial Risk Management LLC
Milliman Financial Risk Management LLC is a global leader in financial risk management to the retirement savings industry. Milliman FRM provides investment advisory, hedging, and consulting services on $184 billion in global assets (as of March 31, 2015). Established in 1998, the practice includes over 130 professionals operating from three trading platforms around the world (Chicago, London, and Sydney). Milliman FRM is a subsidiary of Milliman, Inc.
Milliman, Inc. (Milliman) is one of the world’s largest independent actuarial and consulting firms. Founded in Seattle in 1947, Milliman has 55 offices in key locations worldwide that are home to over 2,600 professionals, including more than 1,300 qualified consultants and actuaries.
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Footnote:
1 Bloomberg LP, as of May 31, 2015
2 Milliman Financial Risk Management LLC, 2015
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