Bonds are among the best performing asset classes of the past 40 years. But it’s not unlikely the next 40 years will show a radically different picture. 2021 and 2022 could even yield negative returns as above-average economic growth and rising inflation could push bond yields up from their record-low levels.
The table below shows that bonds have done great over the past four decades. However, returns have fallen steadily from 222.7% in the period 1980-1989, to 109.9% in 1990-1999, to 84.7% in 2000-2009 and to 44.5% in the ten years from 2010-2019.
Charlie Bilello, founder of Compound Capital Advisors, expects a negative return for the Barclays Aggregate Bond Index of an estimated -1.8% in 2021, as bond investors have been living on borrowed time. The main reason for their stellar returns has been the spectacular drop in interest rates over the past 40 years. As a consequence, the 10-year US Treasury yield has dropped from 15.84% in 1981 to 0.52% in 2020.
A tailwind becomes a headwind
Now, however, a new problem presents itself: the tailwind has become a headwind. According to Billello, it will not take much to make 2021 the worst bond year in history. At the beginning of this year, the 10-year Treasury yield stood at 0.92%. In response to rapidly rising inflation expectations, the rate has risen to 1.30%. Assuming an average duration of about 6 years, a 100 basis point rise in yields will cause aggregate bond prices to fall by 6%. The longer the duration, the greater the drop in yield.
What could cause interest rates to rise further? Bilello mentions three possible causes: rising government debt, higher GDP growth and rising inflation.
Analysts are worried about the fast rise of US government debt: last year they rose by $4600 billion to 28,000 billion dollars. On top of that, there is a further $900 billion from a stimulus plan agreed in December, and new President Joe Biden’s wish list is also impressive: 1900 billion dollars, which has already been approved by Congress.
And then there is the end of the coronavirus crisis, which is expected to lead to an economic boom. But this has a downside: high economic growth is - historically - accompanied by rising interest rates, as well as a rise in inflation. The consequence? 2021 and 2022 could well become the worst years ever for bond investors.
Powell tries to soothe markets
Jerome Powell, the chairman of the Federal Reserve, downplayed the market unease yesterday. He stated before the US Senate that inflation and employment are still significantly below the central bank’s targets. This means that broad monetary policy will remain unchanged for the time being.
However, it was striking that Powell, in his released remarks, did not address the one thing that worries the market most: the rise in government bond yields with a longer duration. This year, the 30-year Treasury rose by half a percentage point and the 10-year Treasury by 44 basis points.
The Fed chairman said rising interest rates are the result of market expectations that economic activity will return to pre-pandemic levels. This increase, he said, did not mean inflation was about to spin out of control as a result of the cocktail of monetary and fiscal stimuli.