IN THE KNOW

The low rate problem

Feb 22, 2021
  • Dennis Lee, Market Insights Lead

U.S. stocks continue to reach all-time highs, with the S&P 500 index approaching 4,000. But this euphoria may be distracting some investors from a more boring but historic problem: close to zero bond rates.

Stalks and Bonz

To simplify what’s happening, here’s what an investor might assume are the tradeoffs in today’s environment:

Scenario 1: Your cousin is starting an electric seesaw company, called Stalks. “Stalks is the Tesla of seesaws,” she says. You’re skeptical – but she offers you partial ownership of the company for $1,000.

Scenario 2: Your friend Bonnie (she goes by Bonz), asks to borrow $1,000, and promises to pay you $100 every 6 months for 10 years, at which point you can have your original loan back. You know Bonz is trustworthy because she’s often borrows money from many friends and pays them back.

What would you choose? Stalks or Bonz? Why not both?

The 60/40 portfolio in crisis

Ah yes, why not both. Harry Markowitz first proposed the idea of a 60/40 portfolio (60% stocks, 40% bonds) in his 1952 page-turner Modern Portfolio Theory. And it has been an anchor for investors for decades.

Stocks, while riskier, have tended to have higher returns. Bonds, while historically returning less, still yielded enough and tended to have lower risk. The beauty of owning both was that in general, when stocks did poorly, bond prices rose, as investors preferred the steady nature of bonds in times of uncertainty.

But you’ll notice that these assumptions about bonds are in the past tense.

A 40-year decline in the 10-year U.S. Treasury yield

chart showing 40-year decline in the 10-year U.S. Treasury yield

Source: Morningstar and U.S. Treasury as of 1/31/21. Past performance does not guarantee or indicate future results. Index performance is for illustrative purposes only. You cannot invest directly in the index.

It’s stark when you see the numbers laid out. But the bonds have been yielding less and less for a long time. 30 years ago, your friend Bonnie would have paid you those $100 coupons (about 10%) off of a $1,000 investment.

Today, good ol’ Bonz is giving you closer to $10 (1%), and investors need to reexamine that friendship.

A two-fold problem

What’s happening? Not even renowned economists can point to just one reason why rates have been on this consistent downward trajectory. But we do know that over the short-term, the Federal Reserve is setting low interest rates to enable people to spend more and borrow money cheaply, with no plans to raise them in the near future.

There’s a two-fold problem, though. Not only are rates low, but bonds may not help diversify portfolios as much as they used to. During past stock market selloffs, interest rates fell, causing bonds to rally (bond prices go up when interest rates fall).

Today’s yields are so close to zero that there’s not much more room for those rates to fall. A traditional 60/40 portfolio might feel a little like investing without a parachute.  

Why it matters

To some, the low rate problem might feel like a low-grade problem. If you have a long time horizon (say, 30 years), you can simply invest in electric seesaw companies like Stalks, as you may not mind the ups and downs.

The historically low bond rates we’re seeing now are pushing all kinds of investors to pile into stocks because while historically riskier, the potential return is higher than a close-to-zero yield. This is part of the reason why stocks may have rebounded so strongly since the beginning of the pandemic, and why BlackRock is still optimistic about stocks in 2021.

But not everyone can ride out potential stock volatility. The biggest issue is this: retirees have historically depended on the income generated by their relatively safer bond holdings. And those bonds are no longer yielding enough.

What to do about it

As the pandemic kept people out of gyms and into their homes, fitness equipment sales soared. In keeping with that theme, we are optimistic on using a barbell.

barbell comparing bond etfs and flexible alternative MFs

*ETF holdings are typically disclosed daily. This information should not be relied upon as research, investment advice or a recommendation regarding the funds or any security in particular. This information is strictly for illustrative and educational purposes and is subject to change. This information does not represent the actual, current, past or future holdings within the portfolio of any BlackRock client.

Bonds are still a vital part of construction portfolios. Even if they provide less diversification than in the past, they are likely to provide some.

On one side of the barbell, low fee bond ETFs could help maximize returns after fees. If you’re investing in core bonds, you may as well do so cheaply and efficiently.

At the same time, we believe investors might need to consider flexible or alternative bond funds that are specifically designed to seek income or diversification. Investing in both together may be an effective approach.

What you want to avoid are the bond funds in the middle – traditional bond mutual funds that demand a high fee, but mirror the bond universe overall.

The bottom line

The low rate problem is a boring but increasingly urgent problem. Investors that have looked to bonds to generate income and help provide diversification likely cannot stick to what they’ve done in the past. They may need to reexamine their relationship with bonds – and redesign their portfolios accordingly.