Back to the Future: What Time Is It for Bonds?

Investors often ask us how they should think about bond markets in a time of rising yields. Are we facing a situation similar to 1994? Or worse, could it be like 1981, when five-year US Treasury yields soared to 15%? Our answer often surprises them: we don’t think it’s either.

We believe there’s a better comparison that’s much more recent. But first, let’s dispel the 1981 and 1994 repeat rumors.

Runaway Inflation (1981) or Sudden Shock to the System (1994)

The driving characteristic of 1981 was double-digit inflation. In combating that, the federal funds rate soared toward 18%–20%. Today, questions around inflation mostly relate to the lack of it, rather than runaway levels of it.

Many investors claim 1994 as their reference point for the perils accompanying interest-rate hikes. Will improving US growth and falling unemployment trigger a repeat of 1994’s rapid doubling of the fed funds rate from 3% to 6%? Probably not. Speed and surprise were key elements in 1994, and markets felt somewhat ambushed as the Fed rapidly fired about a half dozen rate increases after a long period of monetary calm.

Today, the Fed has taken great care to provide highly transparent communications about catalysts for future rate hikes as well as the likely extent and pace of them—none of which were present in the Fed’s communications leading up to 1994’s initial rate hike. And today’s Fed intends to reduce its quantitative-easing programs before embarking on a normalization of rates, which may take several years to unfold. Which leads us to…

2003–2006: A Better Barometer for Today’s Changes

While not a perfect match, we believe the June 2003–June 2006 period had some pertinent similarities to today: rates rose meaningfully, but slowly—and in response to improving growth over time. The fed funds rate began the 2003–2006 period at multidecade lows (then 1%). Over the first year, 10-year US Treasury yields rose by roughly 100 basis points (bps). The Fed then increased rates by a total of 425 bps over the next two years, with 10-year US Treasury yields climbing another 100 bps.

Compare that to today. Both Fed and market expectations for the cycle suggest a very similar occurrence: an increase of nearly 350 bps in the fed funds rate and about 150 bps in the 10-year US Treasury yield. The big difference? This time, the Fed and markets expect the process to take even longer, approximately four to six years.

How did bond returns fare in the June 2003–June 2006 period? The 10-year US Treasury had an average annual return of –1.3% (–3.7% cumulative return), and the Barclays US Aggregate Index was up 1.5% annualized (4.6% cumulatively). Similarly, we’d expect benign, modestly positive core bond returns again if the same slow-and-steady scenario plays out—especially if the path is as lengthy as currently envisioned.

While the two periods share several key factors, some other elements of the story are different. We don’t think they alter the basic resemblance, but they are important points for portfolio positioning today, and we’ll discuss them soon.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income at AllianceBernstein Holding L.P. (NYSE: AB).

Douglas J. Peebles

Douglas J. Peebles joined the firm in 1987 and is the Chief Investment Officer of AB Fixed Income. In this role, he supervises all of the Fixed Income portfolio-management and research teams globally. In addition, Peebles is Chairman of the Interest Rates and Currencies Research Review team, which is responsible for setting interest-rate and currency policy for all fixed-income portfolios. He has held several leadership positions within the fixed-income division, having served as director of Global Fixed Income from 1997 to 2004, and then co-head of AllianceBernstein Fixed Income from 2004 until August 2008. He earned a BA from Muhlenberg College and an MBA from Rutgers University. Location: New York

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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