While bonds have consistently proven to be a diversifier in a portfolio, there are times when they can be a head-scratcher. A majority of bonds have flourished over the last decade, but replicating this type of performance is a tall order. With interest rates at historic lows and deficits swelling, the search for yield has become that much harder.

In mid-March, as COVID-19 was intensifying, the Federal Reserve decided to cut the Fed Funds Rate to zero and reinstate various quantitative easing programs. The Fed Funds Rate is the benchmark used for short-term lending for financial institutions. Keep in mind this move came after the rate was cut to 1.25% a few weeks prior. In fairness to the Federal Reserve, they were forced to make quick decisions to calm markets and provide much-needed liquidity.

After the Fed’s actions, yields on U.S. Treasuries plunged to near historic lows. As an example, a 30-year loan to the federal government today would have a yield to maturity of about 1.4%. That’s extremely low for such a long period. A similar dilemma is present in many high-quality bond sectors such as municipals and corporates.

Once you factor in inflation, the actual return on these bonds could be way lower. But hasn’t inflation been very low? Since 2010, inflation has averaged ~1.7%, which is well below the ~2.7% average the decade prior.

Predicting inflation is harder than many think. Just because the U.S. “prints” money doesn’t mean inflation is going to happen (see the 2010s as an example). But the reality is if inflation does spike, many bonds could experience negative adjusted returns and have several years of interest wiped out. While alarming, it is important to remember that not all bonds are created equal, and several factors must be considered when making allocations.

One of the big concerns making the rounds currently is the increasing federal deficit. It is expected to reach $3.7 trillion later this year, and this number does not include any additional stimulus bills. Gross domestic product (GDP) is expected to register at ~$20 trillion this year, which puts the deficit at an eye-popping ~18.5%, nearly double the peak from the financial crisis.

Traditional schools of thought may lead us to conclude that given these numbers, investors are fleeing from the U.S. dollar and treasuries. Not only is that not happening, but it’s the exact opposite. The main reason for this could be the simple fact that every country around the globe is experiencing the same issues. In fact, many countries are in negative-rate territory. As bad as a 1.4% yield over 30 years sounds, imagine a negative yield instead.

The U.S. dollar and treasuries remain attractive on a relative basis as no alternative currency can challenge the size, liquidity, and safety. Coupled with the U.S. dollar being the world’s reserve currency, a changing of the guard does not seem likely. The estimates range between 40% and 50% of the world’s debt being priced in U.S. dollars. This provides the U.S. leverage, as it’s in the best interest of the global economy to maintain stability, which means the dollar maintains its status.

Does this mean deficits don’t matter? Of course they do, and there could be repercussions—but as long as investor demand for treasuries remains, there is little reason to assume major changes are on the horizon. Even if rates go negative in the U.S., which many believe is a possibility, U.S. bonds would still be a preferable safe haven over most international bonds.

One of the biggest issues with such low rates is income. Where do investors go for income? This concern is not new. We have been dealing with it since 2008. But now rates could head lower than anyone could have imagined.

To earn a respectable yield, additional risk must be taken, and that comes in the form of investing in riskier bonds or shifting a higher percentage to equities. Quite often, this leads investors to “chase” yield or returns without fully understanding the risks associated. In fact, many do it and don’t realize it because they see “bond” in the name of a fund and assume it is safe.

Individual investors are not alone. This problem extends to pension plans, insurance companies, banks, and many endowments that hold a high percentage of high-quality bonds. Now more than ever, it is important to analyze and understand what you hold and the risks associated. Diversification is the foundation of any investment portfolio, but diversifying within bonds is of utmost importance for retirees and pre-retirees.

There are many elements that need to be taken into account such as income needs, risk tolerance, and retirement date, to name a few.

Our Bethesda, MD financial planning firm understands that everyone’s situation is unique in its own right. That’s why we suggest you work with a financial advisor who can help you create a financial plan that will assist you in making the best and most comfortable decision based on your financial goals and desires.

There is “no one size fits all” approach here, thus making it important to focus on your specific situation.

Discuss your situation with a fee-only financial advisor.

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