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Gazing into the Future … Always Dangerous!

[By Timothy J. McIntosh MBA CFP® MPH]

Given that government bond yields today are at historical lows, the opportunity for price appreciation is minimal. More likely, the collection of interest payments will provide most, if not all, of market returns.

Additionally, interest rates could also trend up over the ensuing decade.  This would result in capital losses as bond prices decline, reducing total return further.  Much like the decade of the 1940s, total returns from bonds will most likely be subdued as either market interest rates remain constant or interest rates trend upwards.

Most certainly, physicians and all investors, cannot expect an average long term return of 5.40%.  A 3% total return over the ensuing decade is most probable.  The problem with this examination is that most individual investors have a substantial portion of their assets in bonds, especially of the government sort.  As the average total portfolio return target for most investors is 6-8% on an annualized basis, investors must expect either a substantial decline in interest rates from the current historic lows, or that stocks will make up the difference.

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Although bonds do present moderate investments returns for today’s investor, without bonds as part of a portfolio, investment losses could be a much higher percentage if invested in stocks alone.  But, stocks do generate a higher rate of return over a long period, in short or immediate term, they may well be outperformed by bonds, especially at critical periods in the economic cycle. Bonds in general are known for the stability and predictability of returns. Bonds, especially those of the government kind, have a low standard deviation (volatility).

In fact, bonds are one of the least risky asset classes an investor can own.  When combining bonds in a diversified portfolio, you will lower your overall risk.  The tradeoff, of course, is the return will be lower than an all stock portfolio.

Most investors have money parked in bonds of the government type, i.e. notes, bills, or bonds.  The reason for this has to do with risk and diversification.  Government bonds have one of the lowest risk profiles of any asset class, and have generally produced consistent returns.  Government bonds are also thought to maintain a very low correlation (a statistical measure of how two securities move in relation to each other) with equities.  The long-term average correlation is about 0.09.

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However, this verity has to be examined on a long-term framework.  In fact, correlations between U.S. stocks and treasury bonds have swung widely over the past eighty years. The correlation was positive for most of the late 1930s and throughout the 1940s.  In the 1950s, the correlation was actually negative as stocks advanced strongly and bonds suffered from declining prices (due to increasing interest rates).  From the mid-1960s until 2000 there was a positive correlation, averaging about 0.50.  The correlation turned negative once gain during the past decade.

This was primarily due to the fact that stocks struggled mightily with two large bear market declines (2002, 2008), while bonds rallied strongly as interest rates declined.  So much of the supposed low or negative correlation depends upon what time period you examine. The principal problem with owning government bonds is the negative correlation an investor is looking for only appears sporadically throughout history.

Assessment

There are a number of risk variables to consider when investing in bonds as they may affect the value of the bond investment over time. These variables include changes in interest rates, income payments, bond maturity, redemption features, credit quality, priority in capital structure, price, yield, tax status and other provisions.

ABOUT

Timothy J. McIntosh is Chief Investment Officer and founder of SIPCO.  As chairman of the firm’s investment committee, he oversees all aspects of major client accounts and serves as lead portfolio manager for the firm’s equity and bond portfolios. Mr. McIntosh was a Professor of Finance at Eckerd College from 1998 to 2008. He is the author of The Bear Market Survival Guide and the The Sector Strategist.  He is featured in publications like the Wall Street Journal, New York Times, USA Today, Investment Advisor, Fortune, MD News, Tampa Doctor’s Life, and The St. Petersburg Times.  He has been recognized as a Five Star Wealth Manager in Texas Monthly magazine; and continuously named as Medical Economics’ “Best Financial Advisors for Physicians since 2004.  And, he is a contributor to SeekingAlpha.com., a premier website of investment opinion. Mr. McIntosh earned a Bachelor of Science Degree in Economics from Florida State University; Master of Business Administration (M.B.A) degree from the University of Sarasota; Master of Public Health Degree (M.P.H) from the University of South Florida and is a CERTIFIED FINANCIAL PLANNER® practitioner. His previous experience includes employment with Blue Cross/Blue Shield of Florida, Enterprise Leasing Company, and the United States Army Military Intelligence.

Conclusion

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Filed under: Investing, Portfolio Management | Tagged: Government Bond Yields, Prognostications Over Government Bond Yields?, SIPCO, Timothy J. McIntosh | 1 Comment »