Investor expectations of further interest rate cuts and the possibility of a slowing economy have led to a stampede into bonds in the last month. As demand for bonds has increased, interest rates have declined to all-time lows. Most recently, the benchmark U.S. 10-year Treasury yielded 1.46%, down from 2.0% in July and near the record low of 1.36% set in July of 2016.
These low interest rates are a boon to borrowers looking to lock in historic low rates for purchasing or refinancing mortgages, but for savers looking to earn a return from safe instruments like bank accounts, CDs, or bonds, the outlook isn’t good.
Savers were just beginning to see some return from their cash over the last year after enduring persistently low rates since the financial crisis. Unfortunately, with yields on the U.S. 10-year Treasury at 1.5%, the days of safely earning something on cash are gone.
The chart above shows the decline in interest rates over the last 30 years. Returns from bonds have benefitted greatly during this decline, with the return averaging 5.4% per year since 1990. (www.portfoliovisualizer.com) Now that yields have already fallen, returns are likely to be much lower, in large part because there is less room for rates to post further steep declines.
How does this affect your portfolio? The expected rate of return from bonds over the next 10 years can be approximated from the current yield on the 10-year Treasury bond, which is 1.5%. If we can only get 1.5% by investing in bonds, how are we going to achieve the 4% return a conservative investor needs? The answer lies in the chart above. The current yield from the dividend payments generated by the companies in the S&P 500 is currenty1.88%, but the dividend yield only represents half the return available from stocks. Stocks benefit from the growth in the economy (GDP), and as the economy grows the dividends and stock prices grow. Therefore, we can get better yields from stocks currently with the potential for future growth in both the dividends and the price.
When investing in bonds, the best return you can get is the stated yield for the bond at the time you purchase it, in this case 1.5%. Investing in stocks, you benefit from the current dividends and the future growth of those dividends as well as the appreciation from the stock price. The chart below illustrates the growth of GDP and the S&P 500 since 1990.