by Ron Surz
Investors should only take risk if there’s a reasonable possibility of reward. In this article I examine the risk-reward trade-offs of 10 year U.S. government bonds. Many have commented that the current interest rate environment does not reward investors since there’s not much room for an interest decline whereas the yield upside is unlimited. Let’s compare and contrast downside exposure to upside potential in order to form a reasonable decision rule.
The decision rule that makes sense to me is to not hold 10 year government bonds if the downside exposure exceeds the upside potential.
- I define upside potential as the return that would be earned if interest rates went from their current level down to zero; this is a pretty optimistic measure.
- I define downside exposure as the return that would be earned if interest rates increase from their current level up to their historic level of 6.5%. If interest rates are currently above 6.5%, I define downside exposure as the risk that interest rates increase by 2%.
Let’s start with a look at the history of 10 year government bond yields over the past 54 years, as provided by the Federal Reserve Bank of St. Louis. Yields are currently at their lowest level, 4% below the historical average.
As you can see, yields peaked at 14% in the mid 1980s and have been declining since. It’s no secret that bond investors in the 1980s enjoyed very nice bond returns.
Now let’s look at the history of upside potential versus downside risk:
As interest rates have declined, so has upside potential because yields have grown closer to zero. At the same time, downside exposure has increased, especially since 2008 when the government started manipulating, and artificially depressing, interest rates. As it stands now, downside exposure exceeds upside potential, making 10 year government bonds very unattractive.
We get another view looking at the history of the ratio of upside potential to downside risk. Anything below one is undesirable, as is the case now.
This leads to an investment rule regarding the duration of our bond holdings, namely don’t hold long term bonds when the upside is less than the downside. As shown in the following table, this rule holds whenever yields drift below 3%, as they did in 2011 and beyond. That’s why we reduced bond duration in our target date funds in 2011. We’ll restore to long term bonds again when interest rates move above 4.5%, as they will someday, and the reward-to-risk exceeds 2.
|Yield||Duration||Upside Potential||Downside Risk||Ratio|
To learn more about Ron Surz, visit him at www.TargetDateSolutions.com.
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