On Monday, July 5, the yield on the 10-year US Treasury bond fell to the lowest level on record, closing at 1.37%. This is just a few basis points (one basis point is 1/100th of 1%) below the previous record low which was set in 2012. It is easy for me to remember that the bull market in long-term bonds began 35 years ago not because I remember it, but I know that interest rates peaked just a few months after I was born. There is an entire generation of investors, myself included, who have never witnessed a significant and sustained rise in interest rates. Real interest rates have also fallen sharply and are currently negative. Even though inflation was approximately 10% in 1981, bond investors still increased their wealth in inflation-adjusted terms because the interest received more than compensated for the loss in purchasing power. However, with annual inflation near 2%, current interest payments are not sufficient to keep investors ahead of inflation. Fortunately for bond investors, they have still done very well recently as bond prices continue to rise and total returns have been generous. Low-interest rates are not just a US phenomenon. Yields across the globe on sovereign bonds are at unprecedented levels, and in many cases are negative. In recent days, the yield on Japanese government 20-year bonds fell below zero for the first time and Japan’s 10-year bonds yield minus 0.275%. According to the Wall Street Journal, across the globe there is currently over $11.7 trillion of sovereign debt with negative yields. Falling interest rates have left investors searching for yield wherever they can find it. It is no coincidence that the best performing stock market sectors in the first six months of 2016 have been utilities, telecom, and consumer staples, all which offer higher than average (although not as high as they used to be) dividend yields.
With the benefit of hindsight, we know that the early 1980’s presented a once-in-a-lifetime investment opportunity. Although it didn’t feel like it at the time (at least that’s what I’m told), the early 1980’s really was the “golden age” for investors as stocks and bonds offered fabulous future returns due to their low prices and plenty of room for improvement in the economy. Investors were disillusioned as past returns had been quite poor and the perception was that inflation could only rise. Unfortunately for investors today, we are faced with the opposite situation. Both stocks and bonds have provided strong returns in recent years, expectations for future inflation are mild, real interest rates are negative, and likely future returns are tepid at best. All this begs the question, what should investors do?
First of all, we think it is important for all investors to accept the fact that future returns will be lower than those of recent years. Given such low-interest rates, there is simply no way that returns for bonds can be anywhere close to the past simply because the tailwind of falling interest rates cannot continue indefinitely. At some point (and I have no idea when) interest rates must stop falling and bond prices will cease to rise. And as interest rates are the bedrock underpinning equity valuations, this will also likely have a detrimental impact on stock prices.
Second, in addition to managing expectations, we believe it is important to limit interest rate risk in both fixed income and stock portfolios. For a long-term bond with a very low yield, even a small uptick in interest rates can wipe out years of interest income. For a 30-year US Treasury bond yielding 2.50%, the price decline as a result of the yield rising to only 2.62% is enough to wipe out an entire year of interest. Limiting interest rate risk may mean some investors hold more cash reserves. Of course, cash earns very little at the moment, but with rates as low as they are, the opportunity cost of holding cash is negligible. For a stock, even though the relationship between interest rates and the price is not quite as direct, some stocks have much higher sensitivity to changes in interest rates compared to others.
Next, taking this a step further, if we don’t want to be a long-term lender in this environment, does it make sense to borrow at low fixed rates? We are certainly not advocating that individuals go out and borrow money to invest (although it may make sense to refinance a mortgage), but rather we think it can make sense to invest in companies run by talented managers that use fixed-rate debt in a prudent manner. In instances where a company can profitably expand its operations, make an accretive acquisition, or repurchase stock at a value price, it is beneficial to fund these activities with sensible amounts of low-cost debt. Along these same lines, there are certain closed-end funds that borrow money at short-term fixed rates and invest the proceeds in higher-yielding assets. Many of these funds currently sell at a discount to the value of their net assets and some will likely perform well especially if rates remain low for a long time.
In conclusion, low and negative long-term interest rates makes owning long-dated, fixed-rate bonds a risky proposition. It is important for fixed income investors to understand that the strong returns recently earned by long-term bonds are not an indication of safety, but rather an indication of increased risk. In order to mitigate the risks posed by low-interest rates, it makes sense to limit expectations going forward, avoid bonds with long maturities, and use low rates as an advantage by selectively investing in leveraged equities and certain types of leveraged funds. I doubt that many investors of my parents’ generation ever imagined in their wildest dreams that interest rates would decline to today’s levels, especially in September 1981 when the 10-year Treasury yielded 15.19% and the Federal Funds Rate was at 19%! We are at the opposite end of the spectrum today and it is just as inconceivable to many investors that interest rates could rise as it was that rates could fall in 1981. We have no idea when and by how much interest rates might increase in the next few years, but we believe investors must be prepared for the possibility, no matter how unlikely it seems.