FREE NEWSLETTER
A KEY CONUNDRUM FOR investors: On the one hand, the data on tactical trading are clear. Frequent portfolio shifts are a bad idea and can damage returns. On the other hand, we shouldn’t be so wedded to the status quo that we’re unwilling to ever make a change.
With this conundrum in mind, it was notable when investor and author Howard Marks declared a “sea change” in the investment landscape and recommended that investors revamp their portfolios. The sea change that Marks is referring to is the recent reversal in interest rates. In round numbers, U.S. interest rates declined by about 20 percentage points between 1980 and 2020. But after bottoming near zero, rates moved up rapidly, with the Federal Reserve’s benchmark rate now north of 5%.
To see why this change in the direction of interest rates is so important, let’s start with some background. Higher rates have lately been a boon to savers, making it easy—for the first time in a long time—to earn a meaningful return on cash and bonds. But higher rates have hurt share prices, for a few reasons.
First, higher rates make it more expensive for companies to borrow. This reduces their profits and, all things being equal, translates to lower stock prices. Second, when bond returns become relatively more attractive, some investors shift their investment dollars from stocks to bonds. At the margin, this puts downward pressure on share prices, since stocks are affected by supply and demand. Finally, because a company’s value should, in theory, reflect the present value of its future profits, higher rates translate to lower stock prices.
While share prices have recovered some of last year’s losses, Marks isn’t so sanguine about their future, and this is where he believes a sea change is underway. Stocks, Marks argues, will see more muted returns in the coming years because they won’t enjoy the tailwind of declining interest rates that had boosted returns for 40 years. Falling rates, he says, were “probably responsible for the lion’s share of investment profits made over that period.”
But going forward, Marks sees stocks facing the three headwinds described above. Bonds, on the other hand, now look comparatively more attractive. Marks points specifically to high-yield bonds, which today are paying close to 8%—not far off stocks’ 10% long-term average. For these reasons, Marks says investors should shift “a substantial portion of portfolios… perhaps the majority” over to bonds.
Usually, I agree with Marks’s recommendations. But in this case, I see things differently and wouldn’t recommend making a big shift into bonds. Why? In his memo, Marks acknowledges several ways in which his forecast might be wrong. Chief among them: Bonds, by their nature, “don’t have much potential for appreciation.” Unless it’s the deep-value end of fixed income—an area not readily accessible to individual investors—it’s hard to realize big gains with bonds. By contrast, stocks have theoretically unlimited potential for appreciation.
To better understand this difference, consider Apple. The company has more than $150 billion in bonds outstanding. What would happen if Apple developed a profitable new product? Its bonds wouldn’t gain even a sliver of value. Apple’s stockholders, on the other hand, would benefit greatly if a new product boosted revenue and profits. While Apple is a special case, this dynamic is universal and illustrates the fundamental difference between stocks and bonds. Stocks allow investors to participate in the upside of corporate innovation, while bond returns are essentially capped.
Despite stocks’ structural advantage, could Marks’s forecast still be correct? If 40 years of declining rates artificially boosted stock market returns, will future returns necessarily be more muted? On the surface, the numbers support Marks’s argument. Between 1926 and 1979, the U.S. stock market’s average annual return was 9%. But between 1980, when interest rates began to drop, and the end of last year, returns averaged a much loftier 11.5%.
These higher returns seem to support Marks’s argument, but where I would disagree is in the interpretation. While it would be nice to continue to enjoy the higher stock returns we’ve seen since 1980, that doesn’t mean the alternative is so dismal. If stock market returns reverted to their pre-1980 level of 9%, that would still beat the returns available today on bonds. That, in my view, is the comparison that’s most important.
Dimensional Fund Advisors offers another lens through which to compare stocks and bonds. Between 1926 and 2022, a dollar invested in the S&P 500 would have grown to $11,527. That same dollar would have turned into just $22 if invested in short-term bonds and $131 in long-term bonds. The comparison isn’t even close. The upshot: While bonds might be relatively more attractive today than they were in the past, the data suggest that bonds will remain relatively less attractive compared to stocks.
Jeremy Siegel, writing in his bestselling book Stocks for the Long Run, provides an even longer-term perspective. Between 1802 and 2012, stocks delivered real returns—that is, on top of inflation—of 6.6% a year. Bonds, meanwhile, returned just 3.6%. To be sure, there have been periods when bonds have outperformed stocks, but that hasn’t been the case over the long term.
A final fly in the ointment for bonds: In highlighting the attractive prospects of bonds, Marks is mainly referring to the 8% yields available today on high-yield “junk” bonds. The trouble, however, is that high-yield bonds, in my opinion, aren’t ideal for individual investors. That’s because, unlike Treasury bonds, high-yield bonds are highly correlated with stocks, with a correlation around 0.9 on a scale from -1 to 1. The implication: When stocks drop, high-yield bonds tend to drop as well.
Consider the first three months of 2020. When COVID-19 emerged, stocks fell some 21%, but Treasury bonds and other investment-grade bonds gained 2% or 3%. This is precisely what an investor would have wanted, and why a stock-bond portfolio is, in my opinion, an ideal combination. But not all bonds are the same. Because high-yield bonds are positively correlated with stocks, they dropped in value—by more than 10%—in those early months of 2020. In other words, they did the opposite of what an investor would have wanted. (You can see a comparative chart here.)
As the old adage goes, there’s no free lunch. High-yield bonds offer attractive returns today, but history suggests they’ll do little to protect a portfolio when the stock market drops. Treasurys and other investment-grade bonds, on the other hand, have low or even negative correlations with stocks and thus should provide good portfolio protection during stock market downturns. But in exchange for that increased stability, their returns pale in comparison to stocks.
Is it possible that stock returns will be lower over the next 40 years than they were over the past 40? Yes. But does that mean bonds are now the better place for the majority of your savings? I would be wary of that conclusion.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
Nicely argued. It seems like understanding risk is a significant challenge for investors, as it can be both underappreciated and exaggerated, perhaps even simultaneously. And, as an accountant friend often points out, the biggest risks may be undisclosed, obscured, or even directly denied, as a current trial seems to keep highlighting.
I recall when I was making 8% in a money fund and thinking I had spending money, but not recognizing the loss due to inflation. For any analysis such as this, the numbers need to be inflation adjusted. If over a given time period an investment goes from $1 to $10 but the value of a dollar goes from $1 to $0.10, then the investor should be commended for not losing money.
Sounds like a time to split the difference.
Indeed, the period of “declining interest rates that had boosted returns for 40 years” is most likely over.
This is due to that fact that, in the mid 1960s, fiscal spending actions conducted by the Johnson administration ( “Guns and Butter” era ) set in motion the creation of a highly unique “interest rate mountain” ( lasting from 1970 – mid 2010s, with rates peaking in 1982). However, absent this interest rate anomaly period, over 150 years, the average range of interest rates ( short + long bond rates ) has been between 2.5 – 3.5%. https://imgur.com/a/baoJ5Oq .
An overshoot of the “range” occurred in July 2020 ( with yields falling below 1%, the ultimate rate “cap” ). And with recent inflation, yields have risen back above the range by a moderate amount. However, the sea change is the advent of rates settling back into the historic long term range ( a rate range that is highly desirable for servicing the interest on the National debt ), with the cap appreciation contribution towards bonds’ total return disappearing.
Starting around 2018, returns and principal growth produced by bonds have started to reflect this, as witnessed by a review of returns produced by the popular Vanguard Total Bond Index https://www.portfoliovisualizer.com/backtest-portfolio?s=y&sl=2GWazLjlait9Vf9OmobYCJ
and a review of the steadily declining annual coupon / dividend yields paid over decades https://imgur.com/a/TAlkyCi . And these coupon payments aren’t adjusted for inflation.
However, there is a bright spot. Research shows that a 50/50 portfolio representative of the Large and Small cap value stock universes / indexes has sustained between a “3.5% – 7%” inflation adj annual withdrawal rate ( “sale of shares”, dividends reinvested ), accompanied by terminal portfolio growth, over seventy one rolling 20 year periods ( and even rolling 30 year periods ) since 1931 ( Charts 2 and 3 https://tinyurl.com/yckmev96 ) – these results produced over a variety of interest rate regimes. Naturally, an investor can own the small and large value stock universes through investment in low expense ETFs.
Therefore, an investor need not rely on exposure to the uncertain future of bond returns, and stick with income that is generated from earnings and profits of US companies.
Always enjoy Adam’s articles.
If our fixed income allocation were mostly short term bonds, I’d consider extending our duration by shifting more to an intermediate fund. As it is, most of our FI allocation is in a stable value fund in a 401k plan. It’s hard to imagine the intermediate fund doing better than the SV, especially on a risk adjusted basis, so I think we’ll be staying there.
That said, I could see moving some cash to a short term bond fund.
To be fair, Howard Marks is talking about a very different security than what manyinvestors use to decrease the volatility of their portfolio – the former being junk bonds that carry equity like risk and return, and the later being government bonds that do not, and also have a low or negative correlation to equity risk. I’m sure Howard Marks is not suggesting that those invested in government bonds to smooth he ride, should sell their government bonds and buy junk bonds.
enjoy reading your commentary and love its thoroughness. The one item most don’t take into consideration in regarding returns, are risk-adjusted returns. Yes markets have returned more than bonds over the long-run, but risk adjusted returns are less.
for example, take in consideration your bond analysis. Yes the Apple price will appreciate, and bonds may not move higher much or at all, but you must consider if Apple moves downward, and yes I know we are all shocked to hear that. I know my bond will pay par value so I at least get my principal back plus coupon payments.
lastly, risk adjusted return. I’m not a fan of bond funds honestly because I like to know my duration and tax situation. Further, if my expected market return is say 9% and risk free rate is 5%, we expect the beta to be low or not market correlated to S&P. So the 4% risk premium I must endure is truly not worth going out into equities when I am getting 5% at the moment, not to mention the 5% expected return with a zero beta, since bonds are supposed to be non correlated asset class.
I guess I’m saying this because risk-adjusted returns matter and most disregard that concept.
I disagree. You can only eat returns, not risk adjusted returns.
Not sure what that means so I’ll take it as a compliment! I’ll presume you meant “get” returns. You are correct but that’s not the argument. If I get 50% in “pick random alt coin” in a year and received 9% in S&P 500, you did receive 50%, but at what cost. Was the return you received actually commensurate with the risk you took?
just because my portfolio got a return doesn’t mean it was worth taking on additional risk to receive that return. In portfolio management, we measure everything with risk/return. Are we receiving enough return per level of risk we are taking to justify the investment.
Another great article, Mr. Grossman. But, could someone please explain
exactly what is meant by,”…the deep-value end of fixed income..”, I assume
those investments are available to institutional traders, or similar,or very high
net worth investors,only? Thank you.
The “deep-value end” would include bonds of companies that are on the verge of bankruptcy or going through reorganization under the supervision of the bankruptcy court. Almost all mutual funds avoid such bonds.
Thanks for the explanation. But it sounds more like the no-value end!
The basic principle of this type of investing is that the sell-off is overdone.
Remember, bondholders are pretty high up in the queue. The bonds may plummet to 5 cents on the dollar because the company is headed for bankruptcy. But if there are enough recoverable assets, the bankruptcy court may award the bondholders 15 cents or 20 cents on the dollar. Savvy investors make three or four times their money.
The key to this type of investing is research – how much are the debts, and what are the assets worth. Hedge funds are good at this sort of research, which may involve actually visiting the company. It’s not for the faint of heard, that’s for sure.
Agreed the yield on bonds warrants some review of portfolio allocations and bond plans. Marks perhaps serves clients who are so overburdened with wealth they can afford to put a match to some of it with junk bonds; that’s not us. I am extending bond duration now that there’s yield but would still love to see bigger term premiums. Our bond duration was mostly short going into 2022.
There seems to be a bit of a sea change with interest rates. Until the US debt-to-GDP ratio comes down (less spending, more taxes or both), and the Fed stops shrinking its pandemic era balance sheet, higher rates seem likely to stay and Mr Market likely to be more volatile.
Until my Social Security starts, our stock allocation will stay more conservative than our long-term target unless stock prices drop a *lot*. Our plans assume real stock returns that are lower than the long-term average.
“overburdened with wealth”
Now that is a cross I’d want to carry.
I could stand a bit more burden, but past some level it seems to bring lots of new headaches and not more “happierness”
I have not changed my stock mix during the “sea change” as described in the article…still indexed. I have made changes in my bond portfolio. I did have bond funds in my portfolio, but I have exited all of those in the last 3 years and bought additional individual bonds that are structured into my existing 7 year ladder. This is a mixture of muni, corporate and Treasuries. Every year 1/7th of the ladder matures and I buy more 7 year bonds. I’ve also started purchasing 6 month Treasuries instead of having my cash in a money market fund. I roll them in their own ladder. I make about 40bps over the money market fund as I am saving the fees.
Thanks for the article. I (76 year old retiree) will be sticking with my 50-50 portfolio. And I think I’m going to sell out of the junk bond fund I’ve been holding for a while, it’s only 2% of my portfolio.
Stocks? Which stocks? If you buy conservative, blue chip dividend paying stocks, you can get income that is close to that of Treasury bills, taxed at 0%, 15% or 18.3%, and with some possibility of capital gains. Three years ago, a stock paying 5% was probably a value trap – now there are some pretty good companies with that level of payout. Retirees investing their extra cash might start to look at these stocks, there are plenty of good opportunities.
Thanks, but this retiree is sticking with “boring” index funds.
Spot on and very timely.
You should publish a book. Instead of you quoting Marks, and Siegel,
they (and many others) will be quoting Grossman.