On bonds

Yet again we finished the year with bond yields sitting at or near historic lows. We have written about this before, but as our current positioning in our Global Tactical model includes a position in U.S. Treasury bonds, and we recently upped our allocation to the core bond market index in our Capital Preservation portfolio, we decided to quickly revisit the situation of rising bond yields.

A great proxy for market bond yields in the U.S. is the yield on the 10 year government bond. The St. Louis Federal Reserve, via its FRED site, makes terrific data available to us. Using data from iShares aggregate bond market ETF index fund, we looked at the returns on the bond market when interest rates have risen.

We are lucky in that one of the most dramatic increases in bond rates happened quite recently: From late July 2012 to the end of 2013, the yield on the 10 year bond rose from 1.44% to 3.04% – more than doubling. The chart below shows the yield on the 10 year bond (right hand scale) as well as the rolling 3 month return of the U.S. aggregate bond market (left hand scale). The purple line indicates the end of July 2012 to December 2013. You will see that returns were both positive and negative for bonds while interest rates doubled.

This is a bad thing in bonds- the interest rate doubling in 17 months. How bad? The compound return over that period was -1.29%. That’s right, interest rates doubled quickly and bonds lost a bit over 1%. Incidentally, during that same period stocks in the U.S. rose about 38%

So our takeaway is that when bonds do badly, they don’t do very badly. Recall, the worst full year return in intermediate term (5-10 year) government bonds since 1950 is -4%. But what about when stocks do badly, how do bonds do? For that answer, read on below.

Sources: iShares.com, St. Louis Federal Reserve Bank

Sources: iShares.com, St. Louis Federal Reserve Bank

From the end of April 2010 to the end of September 2011, stocks went basically nowhere or were negative. The U.S fell about -2%, other international markets fell -12% and emerging markets fell -16%. Ouch. How did bonds do during that time? Using the same data as before, we calculate that U.S. bonds rose 7%.

So our takeaway is this: when stocks do well and bonds do badly, bonds don’t do very badly. When stocks do poorly they do very poorly – as we know from 2000 and 2008. But bonds can do very, very well during those times. We call this asymmetry and like that a small allocation to bonds gives us a sort of insurance policy against bad times in stocks.