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What would the bursting of the bond bubble look like?

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Ben Carlson (CFA) is an institutional portfolio manager and part of a team that manages a portfolio for an endowment fund of a charitable organization. He is the writer of the excellent A Wealth of Common Sense blog where the post below first appeared. Follow Ben on Twitter here > @awealthofcs

Investing in bonds is a hedge against bad investment decisions. They may not earn a high return going forward and may even lose some in the next bear market, but I believe the psychology of holding bonds will stop some people from doing the wrong thing at the wrong time. A portfolio with a fixed bond allocation helps reduce behavioral risk and leads to a higher probability for long-term success.

– Rick Ferri

A lot has been made about the potential for a bond bubble with interest rates near historic lows and not much room to fall any further. Even though rates are down this year, investors have been worried for some time about what happens when rates do eventually rise.

As a quick refresher, bond prices and interest rates are inversely related. So as rates rise, prices fall and vice versa. This makes sense since no one’s going to want to pay full price for a bond that yields 3% if market rates are now at 4%.

The conditions in any two investing environments are never the same, but we do have historical evidence on what has happened in the past when interest rates rose from similar levels as those seen today.

Interest rates on ten year treasuries rose by over 500% from the beginning of 1950 to the end of 1981. Here you can see that rate increase along with the performance of these bonds over that period:

You didn’t make a whole lot of money in bonds during this time, but you didn’t get completely slaughtered either. The worst annual return for bonds from 1950 to 1981 was -5%. That’s a terrible day in the stock market.

What many fail to realize when they call it a bond bubble is that even the worst bear market in bonds is completely different than a run-of-the-mill correction in stocks.  Bond bear markets are more like a death by a thousand cuts rather than a straight dive down. That’s because fixed income and equity securities aren’t structured in the same way and have completely different risk profiles.

Investors should really be worried about inflation risk as opposed to interest rate risk in bonds.  Look at what happens to the bond performance over that same period once you take into account the inflation rate:

Bonds weren’t really crushed by the rise in interest rates.  Higher rates affected performance, but nominal returns were still positive because eventually investors were able to make up for the price losses through the increases in yield.

The real returns paint a completely different picture as your purchasing power was slowly eroded over time in bonds in an inflationary environment.

There could be more pain in other sectors of the bond market based on credit quality and maturity, but the point is that bonds were never meant to be long-term return enhancers for your portfolio.

This isn’t anything new.   Over multi-decade time horizons, bonds have never really been the most consistent way to beat the rate of inflation. They pay you a fixed amount of income, so as inflation rises you are getting paid less and less from a purchasing power perspective. Your mortgage works the opposite way in your favor as those long-term debt payments slowly decrease from inflationary pressure.

So does this mean you should dump all of your bonds for fear of a rise in rates or inflation?

Not if you’ve determined that they fit within your risk profile and asset allocation plans. If you just sat on bonds from now through the next few decades will you be happy with your performance? Probably not. But if you use them as a source of stability and for rebalancing purposes then yes, bonds still have a place in a well-diversified portfolio.

Bonds were not a great long-term investment in this 30+ year environment of rising rates and inflation. That’s obvious. But bonds did their part when stocks went down. When stocks fell 11% in 1957, bonds were up nearly 7%. In 1966 when stocks fell almost 10%, bonds were up 3%. And when stocks fell 37% from the start of 1973 through the end of 1974, bonds were up nearly 6% in total.

In a diversified portfolio, you use your bonds to buy stocks or for spending purposes if taking distributions from your portfolio. Then, when the stock market falls, you aren’t forced to sell your stocks at a low point in the cycle and lock in losses.

In that way bonds act as your dry powder during stock market sell-offs in the same way that you should harvest stock gains into bond funds when stocks are in a bull market.

It’s not going to be possible to have the same type of 5-6% annual returns in high-grade bonds that investors have become accustomed to for the past 30+ years. The returns will be much lower going forward from here.  But bonds can still play a role in your portfolio with the correct perspective, plan and expectations.