Yields are still low but the Federal Reserve is expected to lift interest rates further. Conventional wisdom says that this scenario makes bonds a toxic asset class going forward. Maybe, but the analysis is more nuanced when we consider fixed-income from an asset allocation perspective, as a recent report from AQR Capital Management advises.
The analysis starts by recognizing that projecting total returns generally is difficult, but it’s easier for bonds. If you buy a 10-year Treasury Note at a 2% yield and hold till maturity, it’s reasonable to assume that you’ll earn a 2% return. It follows, then, that low current yields imply low returns for bonds. Does that mean that we should cut bond allocations to the bone or avoid the asset class entirely? Not necessarily, as analysis by AQR Capital Management reveals. The main takeaway: holding a broadly diversified portfolio across asset classes remains no less compelling in a low-yield environment that may or may not give way to sharply higher yields in the near term.
“The odd environment that prevailed in 2016 and persists in 2017 does not contradict the strategic case to maintain a diversified asset allocation,” note the authors of Asset Allocation In A Low Yield Environment. “Rather, it highlights the continued need for investors to diversify across more traditional and alternative return sources and size those return sources so they matter in their portfolio.”
The entire study is worth reading, offering valuable insight on the relationship over the last half century between yields and returns for asset classes. Let’s focus on one part of the paper, namely, the historical record since 1966 on starting yields and subsequent returns via two charts.
The first graph summarizes what should be obvious: current yield tells you most of what you need to know about a bond’s expected total return. Lower (higher) yields tend to be associated with lower (higher) returns in the following decade. Note that the relationship is quite strong for bonds and stocks.
