Opinions Investor's Corner John Gudritz's Investor’s Corner - Changing strategies in a low interest rate environment
Order Reprints
Follow @MiBiz
Investor’s CornerBy John Gudritz CFA
Principal
Front Street Investment Management LLC
This e-mail address is being protected from spambots. You need JavaScript enabled to view it
Remember last year when the pundits on the various financial market programs were telling individual investors they were “crazy” and “irresponsible” to be putting their hard-earned savings into bonds? Guess what? While the stock market is down almost 10 percent year-to-date – as of Sept. 23, 2011 – according to the S&P 500 Index, the total return from owning a long-term (over 10 years) U.S. Treasury bond so far this year is about 28 percent.
I would have never imagined in my career that I would actually see levels of interest rates that have not been around since the 1940s and 50s. Thanks to the Federal Reserve’s questionable monetary policy since the recession, short-term interest rates have been anchored at about zero percent. No one has been able to make any real money (after inflation) from money market funds or bank CDs for quite awhile. Now we are watching longer-term interest rates fall to levels most of us have only read about in history books.
For example, the yield on the 10-year U.S. Treasury note has declined from 3.3 percent at the beginning of this year to 1.84 percent. That has allowed mortgage rates to tumble to about 4 percent, and I would expect that decline to continue into next year. Now if we could only figure out how to help people who are “underwater” with their mortgage to refinance their loans.
Since the beginning of the last recession in the fourth quarter of 2007, the yield on the 10-year Treasury note has fallen from 4.5 percent to 1.8 percent. If you had purchased that 10-year note back then, you would have seen the price of that bond increase by more than 16 percent. You would have earned that 4.5 percent coupon each year. That’s not bad considering that the S&P 500 Index is still down more than 20 percent from where it was almost four years ago.
With long-term interest rates so low and looking like they will go even lower, especially if our economy does dip back into a recession, investors are probably safe for the moment maintaining their bond investments. It is reasonable to believe the 10-year Treasury yield could decline to 1.25-1.5 percent, possibly lower. However, there will come a time – probably in 2012 – when the trend in interest rates will change and a secular bear market in bonds will take hold.
If you thought investing your retirement savings was challenging over these past 10 years, you ain’t seen nothin’ yet. Just when the stock market finally finds a bottom that investors like me can believe in and start aggressively investing in again, the bond market will be giving investors nightmares of negative returns as interest rates rise with an improving economy.
At this point, the bond market is getting very risky because shorter-term, two- to five-year yields are so low that investors could quickly see losses in those bonds should the economy truly recover and the Federal Reserve change their policy to a more normal one.
For example, a five-year Treasury note currently has a yield of 0.873 percent. If, in a better economy, the yield doubled to 1.74 percent over the next year, the total return would be a loss of 3.3 percent. The fact is in a more normal recovery, one could expect that yield to increase substantially more and the losses to grow, especially if inflationary pressures were rising.
Instead of buying bonds today in the search of income and “safety,” I have been looking at stocks of good quality companies that have a long-term record of paying and raising their dividends. Because I believe the stock market is still in a secular bear market, I only use market corrections to build these positions in the portfolios. This is truly a time when patience will be rewarded.
I believe bonds will play less of a role in investors’ investment strategies in the coming years. As in the 1970s, they will once again be called the “confiscators of wealth” as their prices fall and inflation rises. At some point, after short-term rates recover to a more normal level, investors will find that maintaining short-duration bond portfolios is a winning strategy, but that is a subject for a future column.