Bonds and Returns (Or Lack Thereof)

With the 60/40 portfolio model stepping up to trial this Wednesday in our NEST Edge webinar, we thought it couldn’t hurt to take a quick glance at the bond market. (Register for the webinar here!)

The 60/40 model suggests that you should allocate 60% of your portfolio to equities (stocks), and 40% to bonds. The general idea is that the bonds will function as a reliable foundation for your portfolio, a sort of anchor while the equities ride the waves of the market. We can already feel Sean’s blood pressure rising at the mention of the 60/40 model and this outdated justification, and he’ll be discussing why 60/40 doesn’t work in much more detail in the webinar, so we won’t linger on that too long. 

Instead, we’ll break down bonds and the current state of the bond market and let you decide for yourself whether you want 40% of your assets allocated there.

Bonds and Inflation 

There was a time not long after the dinosaurs roamed the land when you would buy US Treasuries for the dividends and a guaranteed return of your capital. In modern times, however, buying a US Treasury will give you 1.5% interest annually, which is lagging inflation by about 3.5%. 

So, as of today, buying a US Treasury costs you 3.5% a year in purchasing power. Unless you’re aiming to lose money, this means that relying on bonds to hit your return goals isn’t necessarily the best or smartest strategy. 

Bonds and Yields

But losing purchasing power isn’t the scariest repercussion in the bond market. Let’s take a step back – the bond market is way larger (roughly three times larger) than equities, and it is more influential than most people realize. The US Treasury Market has a direct and massive influence on currency markets and interest rates, and it’s at the root of why the US Dollar is the global currency. 

The US has the most liquid and most functional bond market on the planet by a Texas mile. Most of the cookie cutter bonds in your standard 60/40 portfolio are US Treasuries. The first issue with bonds lies in the US Treasury yields. We realize that’s a buzz word, but all that “US Treasury yield” means is the return on investment (as a percentage) on the US government’s debt obligations. Another way to look at it is the interest rate that the US government pays to borrow money for a period of time. In addition to many other things, US Treasury yields influence how much the government pays to borrow and how much investors earn by purchasing government bonds. Bonds and interest rates have an inverse relationship. 

Junk Bonds

Bonds come in two varieties: investment grade and junk bonds. Yeah – “junk” bonds, which just sounds like it’s going to deliver amazing returns in a portfolio model, right? Before we define these two types of bonds on a high level, understand first that bonds are debt. When a company issues bonds, they’re borrowing money at a specific rate of interest to be paid back, and the capital is due at some point. 

Healthier companies’ bonds are called investment grade, and there’s a good chance they will pay back the loans with interest. The risk is lower, so the interest is lower. On the other hand, garbage companies can issue bonds as well. There’s less chance that they will pay them back, since these companies could go under. So they pay a higher interest rate to offset that risk. 

The line between investment grade bonds and junk bonds is super blurry right now, and junk bonds were at a record high at the start of 2021. There are more and more government bonds issued to offset the national debt, and most of these are junk bonds with higher interest rates and prices. This brings down the yield on older existing bonds despite the risk incurred by taking on the debt of these garbage companies that are unlikely to be able to ever pay it back.

Let us use a straightforward example: if you have a bond that costs $10 and pays a dividend of $1, then that bond has a yield of 10%. If the price of the same bond goes up to $11, then that same $1 dividend is now 9% of the price, so the yield is now 9%. If the price goes up, the yield goes down, and vice versa. The higher the national debt, the higher bond prices are to try to pay off that debt, and the lower the yield becomes. 

Bonds and National Debt 

If COVID was an atom bomb to our economy, the bond market in the US is a thermonuclear warhead at the bottom of a pool filled with gasoline on fire. Corporate America’s debt was at historic levels coming into 2020, and with COVID delivering the ultimate party foul, 2020 was the biggest year of new corporate debt in history. 

In short – we had a debt problem before COVID and corporate America got through it by adding more debt. The Treasury has proven again and again that they will step in to keep this from coming to a head, and in fact, it’s this involvement that has and will keep bond rates low for some time. But if this did go sideways… the ensuing explosion would make the 08-09 housing crisis look like a firecracker. Bonds could be the scariest market to be in at the moment, in our humble opinion.

Sean and Dan will speak more on the bond market and how NEST models focus on returns rather than portfolio theory in this month’s NEST Edge webinar, this Wednesday at 12:30 PM CST. Register here! 

DISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this webinar are for educational purposes only and are not investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net – that email goes right to the partners’ inboxes.

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