A Look Back at Bonds in a Low-Rate Environment
The Federal Open Market Committee (FOMC) is the group which establishes interest rate targets for the Federal Reserve’s monetary policy. On December 14, 2008, the FOMC cut the federal-funds rate to near-zero, where it has remained for nearly seven years. During that time, our investment team has addressed many questions related to this interest rate policy, mostly regarding how the unprecedented environment would impact bond returns. Common questions we’ve fielded, all of which remain relevant, include:
“Rates have nowhere to go but up – shouldn’t we sell our bonds?”
“Why would I want to own bonds which are yielding so little?”
“Shouldn’t we look at commodities? I’ve heard they are a great alternative to bonds.”
So, how do you think Truepoint bond holdings performed dating back to December 14, 2008? If you are like many clients we’ve spoken with, you might be shocked to see the results below:
* BofA/Merrill Lynch US T-Bill 3 Mo
** S&P Goldman Sachs Commodity Index
How can it be that bonds returned nearly 40% since the initiation of the FOMC’s zero interest rate target? And what about all the headlines relating to bonds plummeting or not being worth the risk?
While bonds are often considered simple investments with simple rules regarding their relationship to interest rates, that relationship is not always as straightforward as it may seem. Although the federal-funds rate has not changed in nearly seven years, there has been a lot of movement in one- to five-year rates across both government and corporate bonds. That movement has allowed for both appreciation in bond prices (when rates fall) and reinvestment of interest at higher rates (when rates rise).
Looking Beyond a Zero Federal-Funds Rate
On September 24, following the FOMC meeting, Federal Reserve Chair Janet Yellen laid out a detailed case for raising rates yet this year. The FOMC next meets October 27 and 28, and then again December 15 and 16.
Eventually the fed-funds rate will tick up, and that time may be soon. Conventional wisdom is that when rates go up, bond prices go down. With all else being equal, that is a true statement. The problem is that “all else” is almost never “equal.” We don’t know which rates might directionally follow the fed-funds rate, if any, and by how much they might change if they do. This is why attempting to forecast near-term returns is not only very difficult, but dangerous.
Most importantly, it is critical not to lose focus of the primary role of your bond portfolio: to provide stability by offsetting the volatility of stocks. It was easy to undervalue this role amidst the unusually calm stock environment investors have enjoyed over the past few years, but the recently completed third quarter served as a harsh reminder. Regardless of the interest rate environment, high-quality bonds provide you the ability to benefit from the long-term growth of stocks without fearing the volatility.
