Investors snatch up government bonds for a guaranteed 5% return, but is it worth it?
One silver lining to the Federal Reserve’s rate raising campaign is that government bonds are now paying the highest returns we’ve seen in 20 years.
Some U.S. treasury bonds are currently paying a guaranteed yield of around 5% — a far cry from the near zero percent interest rate that savers were earning on cash just a year or two ago.
“I like to tell people when they see borrowing costs go up, ‘don’t get mad, get even,’” said Brian Koble, an investment manager at Baird Private Wealth Management in Pine Township. “Owning shortterm bonds is a way to benefit from Federal Reserve hikes.”
Federal Reserve chairman Jerome Powell indicated this week that the central bank is likely to raise rates again in March and that increase could be higher than previously anticipated. That will raise costs across the board for mortgages, car loans and credit cards in aneffort to slow down the econ-omy.
The bond market has literally been turned upside down by the Fed’s war on inflation.
Interest rates were on a downward trend for more than 40 years until the Federal Reserve did an about-face in 2022 and began aggressively raising rates in order to keep inflation from overheating the economy.
Treasury bond prices took a historic 16.5% fall — it’s worst on record — last year due to the inverse relationship between bond yields and bond prices, which causes bond prices to fall as interest rates rise.
Following a year of painful double digit investment losses in both stocks and bonds, some investors might see a guaranteed return of 5% as the answer to achieving safe returns.
With bond yields this high, why bother with stocks at all, some might ask?
But financial experts say a portfolio overly weighted with bonds could prove to be a losing strategy for investors who are seeking longterm growth.
“Your nominal return, which is 5%, looks great. But when you adjust it for inflation it doesn’t look so great,” said Michael Godwin, chief investment officer at Fragasso Financial Advisors, Downtown. “Your real return is going to probably be negative [since inflation is much higher than 5%] assuming you live the same way you’ve always lived and you go out spending money.”
The downside of higher bond payouts is that they coincide with record high inflation. And bonds might also be flashing other warning signs for the U.S. economy.
‘Likely headed for recession’
The bond market isn’t working like it normally does because it is experiencing what is known as an inverted yield curve.
That means the yields on shortterm bonds — those with maturities of three-months to two-years — are actually higher than the yields on long-term 20-year and 30-year treasury bonds, which pay closer to 4%.
It’s supposed to be the other way around. In normal times, the yields on short-term bonds are notably less than the yields on long-term bonds because investors are locking their money up for a longer period of time and thus get rewarded with a higher rate.
Inverted yield curves often foreshadow a recession.
“The bond market is saying we’re likely headed for recession,” said David Root Jr., CEO of DBR & Co., Downtown. “The bond market is believing that the Fed is going to continue to raise rates.”
What’s worse, he said, is that the yield curve for short-term and long-term bonds is inverted to the furthest point since 1981. That year, the 10-year treasury shot above 15% while the 2-year bond almost hit 17%.
“If you go back to 1981, we actually had a double dip recession, which started in the second quarter of 1980 and lasted about six months,” Mr. Root said. “Then, it started in the third quarter of 1981 and lasted 16 months. So, it was a kind of brutal double dip recession back then. And the inversion we have right now is rivaling that of 1981.”
Paul Volcker, who was Fed chairman at the time, slammed the brakes on the economy by raising interest rates to 20% in June 1981.
“Back then, you could actually buy a 2-year treasury and earn a 17% yield,” Mr. Root said. “The inverse to that is when you went to get a mortgage, you were likely to pay 15% or 16% interest.”
Stocks represent a share of ownership in publicly traded companies. People who buy U.S. bonds are loaning money to the federal government for a specific time frame. They receive a fixed rate of interest until the bond matures.
Bond investors can either hold a bond until it matures while collecting interest or sell the bond before it matures. Right now, the risk-free yields on bonds are giving stocks more competition for investor capital than they have in 20 years, Mr. Root said.
“But here’s the thing. It’s essentially short-term. The treasury yield curve is saying that yields are high now for maybe the next 18 months to two years,” Mr. Root said. “If the economy is in recession like in 1981 — or anything close to that — the Fed will be reversing and cutting rates.”
Stocks or bonds long-term?
Investors who got burned last year when stocks tumbled nearly 20% might prefer the safety of bonds, especially since stocks could be prone for more turbulent days ahead as the economy tightens and company earnings are put under pressure.
But while government bonds haven’t been this attractive in two decades, financial advisers say stocks are still more likely to outpace inflation in the long run.
“I would not go very, very heavily into bonds,” Mr. Godwin said. “We think it makes sense to maintain a balanced approach.”
Last year was an extraordinary time in history. The S&P 500 Index and the benchmark 10-year treasury both fell in value by double digits — 18% and 16.5%, respectively.
Some folks are still leery of stocks.
According to Refinitiv Lipper Research, investors have been piling into fixed income investments like bonds and money markets at a growing rate while avoiding stocks.
Last week, $55 billion moved into money market accounts which often yield 4% or more. That inflow was one of the top 20 largest weekly inflows in Lipper’s records.
Investors deposited $2.9 billion in capital into Government-Treasury exchange traded funds while pulling $13.5 billion out of stock funds, including $2.3 billion in funds which came out of the S&P 500 exchange traded fund, according to Lipper.
Financial advisers say what’s important to remember is that stocks are long duration assets while short-term treasuries are not.
“When those bonds mature, rates are probably going to be lower in the future because the Federal Reserve is going to have to cut rates at some point, probably in 2024, we believe,” Mr. Godwin said.
“Stocks generally outperform inflation over a long-term period,” he said. “Whereas, the treasury bonds that we’re investing in now are likely to give a real return of next to nothing with inflation.”