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Asset No. 2: Bonds

ON SEPT. 30, 1981, the yield on the benchmark 10-year Treasury note hit a high of 15.84%. Almost four decades later, on Aug. 4, 2020, the yield plunged to 0.52%. And that, in many ways, was the big financial story of the past four 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’s yield so low, 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 high-quality bond yielding, say, 2%? You shouldn’t expect to collect anything more than that.

Moreover, that yield may turn out to be less than the inflation rate, which was 2.3% in 2019, plus the ride in the years ahead may be rough. 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 2%—and that assumes you lean toward corporate bonds and hence take a moderate amount of credit risk. That 2% or so may barely outpace the inflation rate.

Next: Bond Market Risks

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