Interest rates go up. And down. And up.
Over the past 64 years (1948-2011), that is exactly what has happened. During the 34-year period from 1948-1981, the Federal discount rate increased-not every year, but as a general trend, as shown in Figure 1. In 1948, the Federal discount rate was 1.34 percent, and by 1981, it was 13.42 percent. During this time frame of rising interest rates, the 34-year average annualized return for U.S. bonds was 3.83 percent. The year-to-year performance of U.S. bonds is represented in the graph by the vertical bars.
Starting in 1982, the Federal discount rate began its downward trend. At the end of 2011, the rate was 0.75 percent. During the last 30 years (1982-2011), the average annualized return of U.S. intermediate bonds has been 8.98 percent (see Figure 1).
Clearly, the last 30 years have provided a wonderful environment for bonds to perform well as the Federal discount rate steadily descended. Interestingly, U.S. stocks (represented by the S&P 500 Index) performed essentially the same during both periods. From 1948 to 1981, when interest rates were rising, the S&P 500 Index had an annualized return of 11.00 percent. During the recent 30-year period of declining interest rates, the S&P 500 Index generated a 10.98 percent annualized return. Whereas bond returns are markedly impacted by interest rate movement, stocks are largely immune—they march to a variety of drummers. Furthermore, cash (as represented by the three-month T-bill) averaged 4.49 percent during the 34-year period of rising interest rates, and 4.88 percent during the 30-year period of declining interest rates.
With this review of history now in mind, the question of the day is, If I expect interest rates to rise, should I avoid bonds going forward?
First, let’s clarify something. Are we talking about avoiding bonds as our only investment asset, or, are we talking about avoiding bonds as one of the asset classes in our overall asset allocation models? I will assume we are talking about the latter question. To those who invest all their money in one asset class-such as a 100 percent stock portfolio or a 100 percent bond portfolio—this article is not for you.
Let me demonstrate. A one-asset portfolio that held only U.S. bonds (U.S. intermediate government bonds from 1948-1975 and the Barclays Capital Aggregate Bond Index from 1976-2011) was clearly impacted by the period of time. During the 34-year period of rising interest rates, a nondiversified all-bond portfolio averaged 3.83 percent per year, whereas during the last 34 years, it would have produced an average annualized return of 8.98 percent (see Figure 2). Realistically, a one-asset portfolio is not a prudent design.
How about a two-asset portfolio? Let’s assume the classic “balanced” design with a 60 percent allocation to stocks (S&P 500) and a 40 percent allocation to bonds (rebalanced annually). As shown in Figure 2, the differential in performance between the two time periods (1948-1981 and 1982-2011) is much less dramatic, but it clearly favors the more recent 30-year time period, which was more favorable to bond performance-which affected 40 percent of the two-asset portfolio.