People often ask me, “What’s the point of owning bonds with such low interest rates?”
I’ve heard this question for most of my career, and although the risk profile of holding bonds has changed, they still have the same goal in a portfolio that they still have:
To give you stability when you need it most (usually when the stock market is down).
To provide you with an income that makes them superior safe haven assets over cash.
As I explained before, this is just as true in a low throughput environment as it is in a high throughput environment. In fact, if you are a bond holder with the appropriate time horizon (holding bonds to maturity), you actually want the rates to be to augment you can thus rebalance your bond portfolio into more income-generating instruments.
Read: Consumer prices soar again, pushing the US inflation rate to its highest level in 31 years
But what if the rates don’t go up? What if the inflation that everyone is worried about now does not persist? What if the United States looks a lot more like Germany and Japan than it does Zimbabwe or Argentina?
In other words, what if long-term interest rates in the United States slowly take off for zero percent? That’s a pretty opposite view at this point, but much more likely, in my opinion, than the possibility of hyperinflation.
The basic theory is as follows:
Fiscal policy combined with the intervention of the Federal Reserve causes inflation (short term).
Whenever the government and the Fed relax their policies, the stifling secular deflationary trends of technological growth, globalization, demographics and inequality reinforce the downward trend in inflation and interest rates.
The economy is slowing, the Fed and the Treasury react at some point with additional intervention.
Rinse, wash, repeat as secular trends stifle these government interventions.
If rates were to ultimately continue their secular trend towards 0%, the 10-year Treasury bill would earn a total return of 15.5%. Not bad for an instrument with a yield of 1.45% with the highest credit quality in the world.
Of course, smart asset allocation is not an all-or-nothing business. We don’t need to choose to only hold hyperinflation hedges Where deflation hedges. We can choose to own a wide variety of assets that protect us no matter what.
I have said several times over the past few months that this is perhaps the most confusing investment environment in history. That’s why we shouldn’t overlook any potential scenario, including one in which long-term interest rates hit 0% and bonds end up outperforming most other asset classes.
Â¹ – I am a strong advocate for using bonds as a form of insurance during and around retirement to help increase the predictability of returns during this very unpredictable transition period for retirees.
Cullen Roche is Founder and Chief Investment Officer of Discipline Funds, a financial advisory firm. He is the author of the blog Pragmatic Capitalism, where this column first appeared. Follow him on twitter @cullenroche.