Asset No. 2: Bonds

On Sept. 30, 1981, the yield on the benchmark 10-year Treasury note hit a high of 15.84%. Almost 35 years later, on July 5 and 8, 2016, the yield touched bottom at a slim 1.37%, according to Federal Reserve data. And that, in many ways, was the big financial story of the past three decades. As interest rates fell, bond prices rose. That enriched existing bondholders, while also boosting enthusiasm for stocks, which appeared more attractive as bond yields declined. The fall in interest rates made it cheaper for almost everybody to borrow, including corporations, governments and homebuyers.

But the big decline in interest rates is over. With the 10-year Treasury note finishing 2016 at a yield of 2.45%, there’s precious little room for interest rates to fall further—and ample room for them to rise. That means that, from here, all bond investors can reasonably expect to earn is the yield on the bonds they buy. Just purchased a 10-year Treasury yielding 2.45%? You shouldn’t expect to collect anything more than that.

That 2.45% is barely above 2016’s 2.1% inflation rate. Moreover, the ride in the years ahead could be rough. In recent years, the Federal Reserve has artificially depressed interest rates in an effort to spur the economy’s growth. But as the Fed retreats from its loose monetary policy, interest rates could climb, driving down the price of existing bonds. Remember, interest rates and bond prices move in opposite directions, so rising rates mean lower prices for existing bonds.

How high could rates climb? Historically, bond yields have closely tracked nominal economic growth. For instance, if GDP grows at 4% (including inflation) over the next few years, the yield on the 10-year Treasury note could rise toward that level. What to do? You might start by looking at your bond portfolio, considering the risks you’re exposed to—and asking how you would react if the worst came to pass.

Our Humble Opinion: While a globally diversified stock portfolio might return 6% a year over the next decade, bond investors probably shouldn’t expect to earn much above 3%—and that assumes you lean toward corporate bonds and hence take a moderate amount of credit risk. That 3% or so may barely outpace the inflation rate.

Next: Risk and Bond Returns

Previous: Fundamental Indexing

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