Car Hops To Camelot: Lessons Learned From A Bond-Unfriendly Era
Part 1: How a ‘stra-tactical’ approach can help investors stay ready for change This series uses historical economic snapshots to explore how a “stra-tactical” investment approach that combines strategic and tactical allocations can help investors manage volatility. This first blog looks at the bond-unfriendly period during the 1950s and early 1960s. Part 2 examines the bull equity markets of the 1980s and 1990s, while Part 3 looks at flows into equity and fixed income markets since the Great Recession. With prospects of continued volatility in equity and fixed income markets, maintaining a strategic allocation to assets that perform differently in various economic environments can help investors avoid having one asset class dominate portfolio performance. At the same time, investors need a stra-tactical investment approach that affords the flexibility to tactically pursue specific investment opportunities without going all-in or all-out of an asset class. This blog explores the reasons why this approach, with a meaningful allocation to bonds, may have benefited investors at certain times during the ’50s and early ’60s. Unhappy days for bonds The 1950s are commonly regarded as the worst for bond returns. In the rising interest rate environment that began in 1950 and extended through the Great Society in 1965, bonds returned around 2.0% on average, while stocks returned 16.2%. 1 Part of the reason bonds performed poorly during the period is that the absolute level from which interest rates rose at the beginning of the decade was artificially low – at or below 2.5%. 2 To maintain stability in the financial system preceding and during World War II, the Federal Reserve (the Fed) agreed to take steps that kept interest rates low, with short-term rates below 0.375% and long-term rates below 2.5%. 2 This policy ended in March 1950 when the Fed was allowed to resume an active and independent monetary policy. Long-term rates began rising from their low base of less than 2.5% shortly thereafter. By January 1960, they had nearly doubled to 4.7%. 1 When rates start at such a low base, the income on bonds isn’t sufficient to offset the capital loss from falling prices, and total return falls. Investing in bonds during a rising rate environment While this period of rising rates was clearly a hostile decade for fixed income, here are several reasons investors could have benefitted from an allocation to bonds: Stocks outperformed most of the time, but not all of the time . Bonds outperformed stocks in 1953, 1957, 1960 and 1962. 1 These years broadly corresponded with periods of economic slowdown or recession. In a rising rate environment, interest rates rise most of the time, but not necessarily all of the time. While such movements can be short-lived, they could result in portfolio underperformance. The downside for bonds, if held to maturity, is more limited than the downside of stocks. Even in the worst year (1959) of the worst decade, bonds were down 2.6%, compared with the worst year (1957) for equities, which were down 10.5%. 1 Bonds were significantly less volatile, in terms of standard deviation, than stocks (by less than half) during the period from 1950 through 1965. 1 History doesn’t repeat, but it can rhyme What does this all mean for today’s investors, who are anticipating a possible interest rate increase by the Fed in December 2015? Investors should resist the temptation to draw direct parallels between this historical period and the current interest rate environment because too many factors affect equity and fixed income market returns. But by looking to this period, investors can glean the importance of: Diversifying a portfolio by sources of economic risk rather than sources of return. A portfolio that can mitigate the unexpected risks of different macroeconomic environments may help an investor’s financial plan stay on track in any interest rate environment. Potentially reducing volatility with bonds even when rates rise. In addition to income, bonds may offer investors the benefit of lowering the volatility of portfolio returns. Instead of making investment decisions based on interest rate bets, investors need to be prepared for different economic outcomes. Talk to your advisor about a strategic portfolio allocation that includes exposure to stocks, bonds, commodities and other asset classes. Sources Federal Reserve Economic Data (FRED), “Historical Returns on Stocks Bonds and Bills – United States,” Aswath Damodran, Stern School of Business, New York University. Bonds are represented by US 10-year Treasuries; stocks are represented by the S&P 500 Index. Federal Reserve Bank of New York, “U.S. Monetary Policy and Financial Markets,” Ann-Marie Meulendyke, 1998, and University of Chicago Press, “Financial Markets and Financial Crises,” Glenn R. Hubbard, ed., January 1991. Important information Diversification does not guarantee a profit or eliminate the risk of loss. Past performance cannot guarantee future results. In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating. Although bonds generally present less short-term risk and volatility than stocks, the bond market is volatile and investing in bond funds involves interest rate risk; as interest rates rise, bond prices usually fall, and vice versa. Bond funds also entail issuer and counterparty credit risk, and the risk of default. Additionally, bond funds generally involve greater inflation risk than stocks. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. 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Car hops to Camelot: Lessons learned from a bond-unfriendly era by Invesco Blog