Buy Bonds Now: Don’t Miss The Moment You’ve Waited For

Bonds are back. By “bonds” I mean all forms of fixed income bought for regular income and safety. This includes Treasury Notes and Bonds, CDs, and highest quality munis. If there’s a place for them in your portfolio buy them. Now.

For the past decade and a half, bonds have been an asset no reasonable person would buy. Treasuries were perfectly safe, of course, but for all practical purposes, they provided zero return. Whenever an article suggested a fixed income position I reflexively rolled my eyes. A fixed income asset which doesn’t produce income has no purpose no matter how safe it might be. The one exception was I Bonds, which I have bought religiously every year starting in 2020 and written about frequently on this site. Whenever there is a reasonable amount of inflation, say 2%, I Bonds have been a decent bet to provide a bit of return. Ordinary Treasuries not so much.

A Very Long-Term Trend Has (Probably) Turned Around

The actual long-term bottom in rates occurred on March 20, 2020. It was also the long-term top in bond prices although most observers were too caught up with the COVID-19 panic to stop and notice. On March 24, 2020, however, I published this Seeking Alpha piece arguing that the March 20 low had a good chance to be the low print for the lifetime of most readers. If the incredibly low rates held the line at this point the U.S. would avoid the fall into negative rates which plagued Japan and Europe (and US rates indeed remained positive). Here’s the upwardly sloping Treasury series as listed by the Treasury on March 20, 2020:

Click to enlarge

Click to enlarge

The numbers were so small that it was hard to dismiss the story told by the sharply rising yield curve, namely that enormous fiscal expansion and governmental largesse would save the economy and the market and lead to an inflationary boom. All that came to pass.

With safe fixed income assets now yielding close to 5% as compared to the puny yields in the above table it is increasingly likely that interest rates have turned a corner and are likely to rise with ups and downs over the next few decades. For now, however, rates appear to have reached the top of the first rally phase. Using the 10-Year Treasury as a proxy, the rate passed the very long-term average of 4.5% (source: Investopedia) in late September. Since then it has risen to tag 5% but fallen since then as if it had hit a stone wall. The 10-Year Yield is 4.81% as I write this line. That should be good enough to serve as a major part of a balanced portfolio.

The Risk Of Missing Out Versus The Risk Of Being Early

The yield curve (again using the 10-Year Treasury) is now modestly inverted. It’s almost flat once you get past short-term Treasury Bills. Those yields on T-Bills are hard to ignore and professionals including Warren Buffett have not ignored them. The thing to remember is that Buffett is a bit different from most of us. He is happy to take the 5% returns on T-Bills when prospective stock market returns offer nothing like that with reasonable safety. When T-Bill rates were much lower he reached for yield with HP Inc. (HPQ), the former Hewlett Packard, a no-growth dividend-paying tech company in irreversible decline. Buffett recently dumped HPQ and jumped on more T-Bills in its place.

No criticism of Buffett although I tried to whisper in his ear to wait a while and found that my whispers don’t extend from Chicago to Omaha. Now everybody wants T-Bills and Buffett is just engaged in debates on the best maturity. The best would appear to be 3-month Bills at 5.41% and 6-month Bills at 5.55%. Vanguard Treasury Money Market Fund (VUSXX) pays 5.32% with all the advantages of Treasuries.

The problem is that these very seductive yields may go up and down rapidly, probably down from the current moment. Meanwhile, T-Bill yields make it all too tempting for fixed income investors to avoid the difficult decision involved in swapping a substantial amount of yield, as much as 75 basis points, for the much more distant maturities of the 5- and 10-year Treasuries.

Much depends upon your assessment as to whether the next move in longer-term rates is up or down. For the past year, I have tilted slightly to the view that it was up. The thing to do was wait a bit or at least keep maturities short. Treasuries and CDs I bought three years ago are now running off over the next six months and I wish they would run off sooner. I could be wrong, however, and there is still a chance that the current modest decline in rates will prove to be a passing blip. My money, however, is with the better odds that the 5% wall will hold for the next several years. If you agree, it’s time to lengthen your maturities to the extent possible.

Be Attentive As To Which Account To Use

What I am about to say is obvious. Assets that generate taxable income should be held in tax-advantaged accounts like IRAs to the extent possible and tax-advantaged assets like munis should be held in taxable accounts. Bear in mind that some states, like my own Illinois, tax muni funds while only Illinois munis receive favorable tax treatment. Keep in mind that the long-time fiscal behavior of Illinois makes them rank near the bottom of all states in safety.

CDs are fully taxed and thus trade with higher yields than Treasuries. I have noticed recently that it is hard to find suitable CDs on the Vanguard list of “sponsored” CDs. That may be a fluke or it may mean that issuers feel that rates are near a top making it a bad moment to sell high-yielding CDs. I’m sure that Janet Yellen and the Treasury wish they had been so smart when yields looked like they do on the above chart. I remember wondering why they were being so stupid as to issue short-term debt at the time. Stanley Druckenmiller, one of the best thinkers in the markets, was reported as having the same opinion in recent days. Now, the Fed is going to have a few years of selling very expensive debt.

Look closely with munis. If you are pushed into a taxable account, calculate your marginal Federal tax rate, dock the Treasury yield by that amount, and see if the muni of equivalent maturity ex state and local tax rate is a good deal. The muni/Treasury spread goes up and down with perceived risk and simple supply and demand. It takes a significant spread to interest me in munis.

Your Personal Needs Are Part Of The Decision

With the Treasury yield curve, relatively flat all the way out to 30 years and all maturities are above the long-term average yield, you can pretty much take the maturity that best suits your own needs. If you are old like me (79), you will want a maturity that fits your own probable mortality so that your heirs won’t have to figure out the strategy you had in mind or at least you will have time to leave them suggestions of what to do. I recently gave myself a couple of extra years, by the way, based on good medical test results and no evidence of dementia so far.

If you are in your twenties or thirties, however, you need a longer-term plan. You might want all equities and no bonds at all. If you are like me, however, and think that bonds will perform better than stocks in the next few years, you might want to have some laddered Treasuries rolling over every six months out to three or four years. If you can’t do something like this for yourself, run it by your advisor.

How About The Legendary 60/40 Portfolio?

The last few years have been the worst times ever for the 60/40 portfolio with bonds throwing off next-to-no coupon income and then more or less crashing for three years. The high moment was the runs on imprudent regional banks early this year when a handful of investors had large enough deposits that a decline in the value of bonds triggered a bank run. So avoid bonds? Goodness no. If there was ever a signal that the bond bear market was nearing its end, the venture capital/crypto bank crisis was it.

In the old days, the rule of thumb was to subtract your age from 100 and that should be your equity allocation. It’s a rough estimate, and my better personal approach is to reduce risk as soon as you have the amount you need and adequate coverage of inflation. I think the 60% stocks/40% bonds portfolio works well for most people who are not young but not quite in sight of retirement.

Let’s do a little calculation. Let’s assume that by composition equities as a whole get 2.75% growth (derived from GDP), 1.62% dividend yield, and 2.4% from inflation (derived from regular Treasury yields less real yields from same maturity TIPs). That’s a 6.77% return. Annual returns will vary, sometimes greatly, but the upside and downside are symmetrical. The 6.77% number is consistent with most other ways of measuring equity returns, if anything a little on the high side.

Now using the current 4.8% of the 10-Year Treasury and multiplying 0.4 (40%) gives a bond contribution of 1.95% to the total portfolio. Multiplying the equity return of 6.77% by 0.6 (60%) gives an equity contribution of 4.06 to the total portfolio. Total portfolio return is therefore just over 6%. That’s not far from numbers being tossed around by professional investors who are somewhat pessimistic about the next 10 years. It is much lower than the low double-digit return on equities over the past decade and a half, but a significant part of those returns had to do with extremely low interest rates.

Inverting the situation with bonds, the major lift in interest rates is likely to produce an extended give-back period for equities. The 40% bond position in a portfolio is likely to provide a steadier return over the next ten years with a modest cost to total return. The bond part of the return, bear in mind, is absolute. Because bonds give you part of your money back in two annual payments (each of 2.4% from the 10-Year) the duration is reduced and the return is increased by assumed reinvestment of the coupons. There’s no uncertainty. With bonds, you know the time and amount for the return of your capital when you buy it.

Conclusion

Since March 20, 2020, bond yields have risen from minuscule amounts to tag 5%, more than their long-term average. With the 10-Year Treasury yielding about 4.8% the return is still above the long-term average but declining as a slowing economy suggests lower inflation and the end of “higher for longer” rate policy by the Fed. Many observers see rates unwinding for a bit with legendary macro investor Stanley Druckenmiller recently making public the fact that he is short Treasury Bills. The message to other investors is to grab the current rates while they last. Buy maturities that fit with your personal needs. Don’t wait too long.