Copyright 2012. Tom Madell, PhD, Publisher
Investors accustomed to high total returns on bonds should be aware that those returns are unlikely to persist much longer. As benchmark Treasury yields approach zero, total returns will likely be less than they have been; as yields increase in coming years, total returns will likely decrease substantially, or even turn negative. This article will focus on the data for the benchmark 10 year Treasury bond and the lessons that data provide for the future.
A chart published by the Stern Business School at New York University provides some very important historical data. The chart reports the total annual return for the 10 year Treasury from 1928 to the present. The total return is composed of the gain (if the yield drops) or loss (if it rises) to the principal over the course of the year plus the actual interest payment during the course of the year.
Between 1928 and 1981, a period of 53 years, the total return on the 10 year exceeded 10% during only three calendar years, on average once in 17 years. By contrast, between 1982 and 2011, a period of 30 years, the total return exceeded 10% during 14 calendar years, approximately once every two years. In short, the total return during the past 30 years exceeded 10% five times more frequently than in the prior 53 years. The 10 year’s performance in the coming decade, however, is much more likely to mirror the return of the first 53 years.
The difference in performance during the two periods is primarily the result of Federal Reserve policies. Following the Depression, the Fed steadily raised the Fed Funds rate to counteract increasing inflation. In 1981, the Funds rate peaked at 20% and the yield on 10 year Treasury peaked at 15.46%. The total return for that year was -4.70%, due to the depressive impact such high yields had on bond principal. Thereafter, the Fed embarked on a long term policy of lowering the Fed Funds rate to intermittently stimulate the economy and counteract recessions.
In late 2008, the Fed lowered the funds rate to essentially zero, where it has remained since that time. Further, the Fed has pledged to keep the funds rate at zero until late 2014. Until recently, it would have been unthinkable that the Funds rate would ever approach zero, no less remain there for six years.
In addition to lowering the Funds rate, since 2008 the Fed has engaged in extraordinary actions to bring down rates on long-term (more than five years) Treasury bonds. The Fed has increased its holdings of long-term Treasuries by over 500% during this period. Starting in 2008, the Fed conducted quantitative easing programs during which it increased its balance sheet in part by directly purchasing long-term Treasuries.
Last October, the Fed began a program called “operation twist” by the financial community during which it intends to sell $400 billion of short-term Treasury bills and bonds and use the proceeds to buy long-term Treasuries. The program is scheduled to expire in June but could be renewed. Last year, the yield on the 10 year fell from 3.34% to 1.87%, in significant part due to the operation twist program. The total return on the 10 year Treasury for 2011 was 16.04%, as the lowered yields positively impacted principal.
Future returns on the 10 year Treasury will be limited because of restricted potential for lower rates. To illustrate, if the yield on the 10 year fell from 1.87% at the start of this year to 1.00% at the end of the year, the total return would be 10.6%. If the yield were to fall to .50% during 2012, an extremely unlikely occurrence next year or in the next decade, the total return would be 15.5%. The potential increase in returns for the 10 year Treasury is thus severely limited by the zero yield boundary for the bond. There comes a point where a further increase in return due to higher principal is no longer possible. As a result, in the coming decade, it is likely that the total return on the 10 year Treasury will not exceed 10% in any single year. When the rate was 15.46% in 1982, the potential for principal appreciation was large. The 1.87% rate at the start of 2012 leaves little room for further principal appreciation.
The implications for the investor seem clear. To a significant degree, the yield on the 10 year Treasury drives yield on all long-term bond rates. In the coming decade, the total return on bonds will almost certainly considerably underperform those of the past decade. As investors allocate their holdings between stock and bonds, they should keep this inevitable shift front and center.
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