Last week we looked at the future returns for stocks and the picture wasn’t pretty. Today we will look at bonds to see if they will help our overall returns.
If you pay any attention to financial markets, you know that interest rates are at very low levels when compared to historical levels. The price of a bond and the interest rate of a bond have an inverse relationship. This means that as rates have fallen over the last 30 years the prices of these bonds have been constantly increasing in price. This capital gain combined with the bond’s annual coupon computes the total return of the bond.
Let’s say you buy a bond for $1,000 which will mature 5 years in the future and pays a coupon once a year of $50 or 5% (you get your $1,000 back after 5 years). One year later you receive your first $50 check in the mail. You now own a 4-year bond. Then, I come along and want to buy a 4-year bond, but over the course of the year interest rates have fallen. I can buy a newly issued 4-year bond for $1,000 and receive a coupon payment of $40 (4%). Alternatively, I can buy your 4-year bond for a certain price and get $50 a year. At what price for your bond will I be indifferent between your bond with a $50 coupon and the bond for $1,000 with a $40 coupon? Obviously you will charge me more than $1,000 to compensate you for the higher coupon payment. Some quick math tells us that I will need to pay you $1,036.30 for your bond to equal the new 4-year bond. You sell me the bond and you make $36.30 from the increase in price and $50 from the one coupon payment for a total return of 8.63%.
In the example, we had a pretty high coupon and falling interest rates. Today we have the opposite, low coupons and very low interest rates. You have to be careful not to say that rates must rise soon. There are many times in history, and now could be one of them, where interest rates have stayed very low for long periods of time.