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A Look at Bonds and Mortgages in Today's Ultra-Low Rate Environment

April 19, 2016

A look at average annual yields for stocks and bonds, by decade for the past forty years, reveals some interesting results.


                        Bonds    Stocks   Difference


1976-1986      10.6%     4.8%        5.8%

1986-1996       7.6%      3.2%        4.4%

1996-2006       5.2%      1.5%        3.7%

2006-2016       3.0%      2.1%        0.9%


Apr 15, 2016    1.8%      2.1%       -0.3%


In the figures above, bond yields are represented by interest paid on 10-year U.S. Treasury notes. Stock yields are represented by dividends paid to owners of the S&P 500 index of stocks. Essentially, yield is the annual amount of interest (bonds) or dividends (stocks), expressed as a percentage of face value (bonds) or price (stocks). The 10-year U.S. Treasury note and the S&P 500 stock index are the standard benchmarks for bonds and stocks, respectively, in the United States.


While rates for both stocks and bonds have come down over the years, bonds have by far fallen the most. In addition, whereas bonds have nearly always yielded a few percentage points more than stocks, today's rate environment has turned this relationship upside down, with bonds actually yielding less than stocks.


The fact that bonds have traditionally yielded more than stocks should come as no surprise, since an investment in stocks comes with a potential for capital gains resulting from rising stock prices, and dividends on stocks have grown an average of 6.0% per year, or 80% per decade over the past forty years. These two factors (opportunity for capital gains and steadily increasing dividend payments) have historically served as justification for investors to choose stocks, even though they offered less in terms of yield than bonds.


In order not to mislead the reader into thinking that the above analysis is a recommendation to buy stocks, let me be clear: I am most definitely not implying that stocks are cheap today. Rather, I am pointing out that bonds appear very expensive. Today's high-grade long-term bonds, such as the 10-year U.S. Treasury note, offer very low interest to their owners - low by historical standards, low when compared to inflationary measures, and low relative to alternative investments.


Consider that the Federal Reserve is officially targeting an inflation rate of 2%, and doing everything in its power to achieve this target. Inflation is the reduction in purchasing power due to rising prices over time - it is the reason that nobody can buy a bottle of Coca-Cola for a nickel any longer (apparently, Coca-Cola last sold for a nickel around 1959). Historically, inflation has measured around 3-4% per year. A 1.8% yield does not provide sufficient income to maintain a dollar's purchasing power at even a 2% rate of inflation, let alone at the higher historical rate.


What about taxes? For the investor paying a 30% marginal tax rate, a taxable bond yielding 1.8% before taxes would yield only 1.3% after taxes. That's just $13 a year for every $1,000 invested, or $13,000 for every $1 million invested - not exactly a grand way to live.


Expenses also hurt bond investors. Most investors do not buy bonds directly from the U.S. Treasury. Instead, they buy mutual funds. According to the Investment Company Institute, the average expense ratio for bond mutual funds was 1.0%. The expense ratio measures the costs incurred by mutual fund companies simply to administer the fund. It covers costs such as bookkeeping, compliance, marketing, and research. When bonds were yielding 10%, a 1% expense ratio would represent only 1/10th of the total yield. Today, with bonds yielding 1.8%, a 1% fee can represent more than half of the investor’s pre-tax yield. Many investors do not even know they are paying such expenses, because they never receive a bill. The expenses are simply deducted from the fund's assets, and unless an investor actually reads the fund's annual report, he or she would likely never know about this cost.


In addition to expenses incurred by fund companies to run bond portfolios, many bond investors pay additional fees to financial advisers. It's pretty typical these days for investors to pay 1% of their invested assets (including bonds) to their investment advisers through commissions, front-end loads, back-end loads, or management fees. Now, I'm not wishing to be critical of investment advisers, as most work very hard and offer valuable services and peace of mind to their clients. I have some very close friends who are in the investment advice business, and these are very smart people. I'm merely pointing out a cost that some of today’s bond investors face.


After subtracting inflation, taxes, fund expenses, and adviser fees, the current yield on the benchmark U.S. Treasury note falls from a positive 1.8% to a negative -2.7% per year, or negative -24% per decade. Ouch. As it turns out, even mattresses can yield more than bonds these days!


Yet even with this horrible return, investors continue to pile into bonds. According to the Investment Company Institute, bond mutual funds contain around $3.5 trillion of assets. But the actual investment in bonds is even higher if one adds the bond investments held in target date mutual funds, balanced mutual funds, and bonds held outside of mutual funds.


It is very interesting to me that investors would continue to choose bonds despite their negative all-in returns (after inflation, taxes, expenses, and fees). One reason that bonds have been, and will continue to be, demanded by investors is that they offer a contractual guarantee. Bond issuers are contractually obligated to pay interest and principal in amounts and on dates as specified in their offering materials. Other types of investments, such as stocks, offer no such guarantee. Yes, bonds offer a contractual guarantee on principle invested, but this guarantee comes with a high price in today’s market.


Another reason I believe the bond situation has continued to spiral downward is that investors have grown accustomed to applying strategies that worked in the past, even though today’s situation is very different. For example, there is an old rule of thumb that an investor should put roughly his or her "age" into bonds. The rule says that a 55 year-old investor should put about 55% of his portfolio in bonds. People still automatically follow this rule, or other similar rules, but I believe that investors would do well to reexamine any of the old rules of thumb when it comes to bonds.


Besides the impact that low interest rates can have on investors, there is a practical way that people, investors and non-investors alike, can actually benefit from today's low-rate environment. This is for people to lock in the low interest rates currently offered by banks on their home mortgages.


Mortgage rates are tied very closely to long-term government bond yields. In the forty years since 1976, 30-year mortgage rates have consistently averaged around 1.8% above the yields on 10-year U.S. Treasury notes, a relationship that continues to hold true today. As yields on long-term bonds have come down, so have the rates on home mortgages. Below is a summary of how average rates on 30-year fixed-rate home mortgages have changed in the four decades since 1976.


                       Mortgage Rate    


1976-1986            12.5%

1986-1996             9.2%

1996-2006             6.9%

2006-2016             4.8%


Apr 15, 2016          3.6%


We are experiencing a time of historically low interest rates, and while this is not good news for the investor in bonds, it is great news for the debtor. I am surprised at the number of people who borrow money for a home at terms that allow the bank to lift the interest rate in the future (known as a floating, or variable rate of interest because it varies according to some benchmark rate of interest). Usually variable rate mortgages come with lower interest payments (at least initially), but these interest payments can skyrocket if the benchmark rates they are tied to rise.


Unfortunately, a lot of people point to the long-term trend of falling interest rates and reason that variable rates will take advantage of this continued trend. However, it is unlikely that mortgage rates will go much lower, as the yield on the benchmark 10-year U.S. Treasury note is currently very close to zero percent. On the other hand, there is no ceiling on mortgage rates (they hit 18.63% in 1981). Seems to me there is little opportunity for rates to fall, and a lot of risk that rates could rise.


Just as low stock prices of the early 1980's offered people a unique opportunity to build wealth, today's low mortgage rates offer people a unique opportunity to lower their total out-of-pocket costs to purchase their homes. If you have a mortgage and are not sure whether it is fixed or variable, ask a representative of your local bank or credit union. No doubt they would be happy to sit down with you and discuss the difference between fixed and variable rate loans.

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