Public sentiment seems to be that now is a bad time to buy bonds or to own bonds. We have heard and seen variations of this sentiment over the past several years but the frequency of this narrative during the past year is alarming. To be clear, it is not simply coming from unsophisticated retail investors. This “bonds are bad to own right now” narrative originates from financial advisors and investment professionals. Professional advisors cite low interest rates as a reason to look for bond alternatives and to move out of investment grade bonds into higher yielding investments or into more stocks. The message is that because interest rates are really low, high grade bonds will provide almost no return and that investors need to go find yield and returns from other asset classes. This message is clearly resonating because most of the sales pitch voice mails and emails we regularly get from investment management firms begin with the promise of an improved alternative to low yielding bonds.

Is this message wrong? Should investors really be leaving high grade bonds for stocks, for higher yielding bonds, for real estate, for alternatives?

Consider the chart below which reflects monthly data back to the inception of the Bloomberg Barclays Aggregate Bond Index in January 1976. The horizontal axis reflects the 10-Year US Treasury yield at the beginning of each month since January 1976. The vertical axis reflects the return of bonds relative to stocks over the subsequent 10 years.

We randomly highlighted a data point from September 1, 1988 to help better understand the information reflected in this chart. At the start of September 1988, the 10-year Treasury yielded 9.3% (horizontal axis). Over the subsequent 10 years (Sep 1, 1988 – August 31, 1998), stocks (represented by the S&P 500 Index) returned 17.0% per year and bonds (represented by the Bloomberg Barclays Aggregate Bond Index) returned 9.3% per year. Bonds trailed stocks over this 10-year stretch by 7.7% per year as reflected on the vertical axis.

With that explanation, let’s consider the important takeaways of all this data in the chart above:

The starting yield for bonds is useless in predicting how bonds will perform relative to stocks over the subsequent 10-years.

In statistical terms, the R-squared of the plots in the chart above is 0.013. This means that the starting yield for bonds explains just 1.3% of the variation in the relative performance for bonds over the next 10 years. Because the plots represent overlapping time periods, 1.3% is actually overstating the explanatory utility of interest rates.

The takeaway? It is naïve and/or intellectually dishonest to cite the current level of interest rates as a rationale that bonds are unattractive relative to stocks. There is no relationship between interest rates and the expected future return of bonds relative to stocks. Shifting from bonds to stocks right now because of the low starting yield for bonds is just assuming more risk in the hopes of a higher return.

Over most 10-year periods, bonds underperform stocks.

Although there were some 10-year periods in which bonds outperformed stocks, every one of these plots overlapped with the 2000-2002 and the 2008-2009 bear markets. Not just one of the bear markets – both of them. The return advantage for bonds in these periods had everything to do with the miserable performance of stocks over the 10 years – not some really attractive starting yield for bonds. Had you known in the late 1990’s that the next 10 years would encounter the two worst stock market declines since World War II, you would have wanted to back up the truck for as many high grade bonds as you could get, regardless of whether the starting bond yield was 1% or 10%. These types of environments (2000-2002, 2008-2009) are precisely the reason to own a consistent allocation of high grade bonds in a portfolio. Because the stock market is risky and stocks can lose 50% or more of their value without any warning.

If you’re buying high grade bonds for their return, you’re doing it wrong. Not just in 2021. In 2005. In 1982. In 1957. In 2057.

The annualized return advantage for stocks over the 45-year period in the chart above was 4.4% per year. Starting with $100,000 investment in 1976 and buying stocks rather than bonds, you end up with an additional $12.2 million by February 2021.

At every single point in history dating back to the beginning of capital markets, high grade bonds have been a lousy ex-ante investment choice if the alternative is stocks and the goal is to maximize expected return. It is all too easy to forget this perpetual and most fundamental concept: the role of high grade bonds in a portfolio is safety. The role of high grade bonds is return of capital, not return on capital. High grade bonds are insurance to the risky activity you undertake by owning stocks.

Bonds do not exist in a vacuum.

Low interest rates do not just impact bonds. They impact money market yields, resulting in less return from holding cash. They impact stock prices, resulting in lower expected returns for stocks. They impact capitalization rates on commercial real estate and expected rental yields on residential real estate.

We know that high grade bond returns will be lower over the next 10 years. The chart below is identical to the first chart above except that instead of using the relative return of bonds to stocks on the vertical axis, it simply uses the absolute return of bonds. There is obviously a much stronger relationship here as evidenced by an R-squared of 0.88. With a low starting yield for bonds, the expected return over the next 10-years will be lower. But here’s the thing: thinking or pretending that low interest rates do not diminish the expected return of all investment categories is likely to be financially deleterious.

So, is it a bad time to invest in bonds?

Now is no better or worse a time to invest in high grade bonds than at any other point in the past? Granted, interest rates are low and that means the nominal return for bonds over the next decade will be low. But, the same is likely to be true for all the alternatives to bonds including cash and stocks. What we should expect over the coming decade is for bonds to outperform cash and for stocks to outperform bonds and for the return of all investments to be lower than they have been, historically.

Again, the real purpose of high grade bonds in a portfolio is always safety and protection. They belong in a portfolio to counter the shock of a stock market collapse, to help reduce the downside risk of a portfolio, and to help you sleep at night. None of this changes because interest rates are low or high. So if a financial professional suggests that reducing bond exposure is a good idea right now because of low interest rates, consider following up by asking whether getting rid of your home, auto, and life insurance right now might also be a good idea.

Less than three months ago – in this December 30^th post – we presented the following chart to highlight the historic disconnect between value stocks and growth stocks.

The underlying point then, which still holds today, was that growth stocks – familiar names with exciting narratives such as Tesla, Amazon, Facebook, Snapchat, and Apple – were dramatically more expensive than their value stock brethren. In fairness, growth stocks deserve richer valuations because they represent companies with exciting prospects and attractive growth opportunities. Keep in mind, however, that growth stocks being dramatically more expensive than value stocks refers to the current relationship relative to the normal relationship. In this context, growth stocks are roughly 5.5 standard deviations more expensive to value stocks than the long-term average (using price/book as the measurement of value). In a normally distributed sample of monthly data, a relationship this extreme should occur about once every 2.2 million years.

We have all learned from experience that extreme events in finance occur more frequently than would be expected in a normally distributed sample. Yet this does not change the fact that calling growth stocks “dramatically more expensive than value stocks” – even if not a once every 2.2 million year phenomenon – probably falls on the side of understatement.

A hypothesis used to explain this unique relationship stems from the environment of historically low interest rates. The theory is that growth stocks are akin to long-term bonds with an underlying value that depends largely on future cash flows many years in the future (think of an unprofitable company like Uber where the stock’s value depends entirely on expected profitability at some point in the future). Declining interest rates make these future profits more valuable because of the reduced opportunity cost of investment alternatives (reduced discount rate). Growth stocks – because they tend to be companies relying on an expectation of high future profits – are then the beneficiaries of low or falling interest rates (just like long-term bonds). Conversely, value stocks are hypothesized to behave more like short-term bonds since they are often mature companies with current profitability where the stock price is not as dependent on large profits many years from now. Keeping with the hypothesis, growth stocks have been the overwhelming beneficiaries of historically low interest rates over the past several years. The other side of this is that rising interest rates – if and when – should favor value stocks relative to growth stocks.

In fairness, academics and practitioners debate about this interest rate hypothesis and the robustness of the relationship between interest rates and the relative performance of value and growth. Debates aside, here is what we can say with clarity right now:

• Interest rates have a clear relationship with stock prices (not value or growth stock prices…value and growth prices). All else equal, higher interest rates mean that future profits are less valuable (higher discount rate).
• Value stocks tend to be less dependent on future profits than growth stocks. All else equal, that makes growth stocks more negatively impacted by higher interest rates. Interest rates may not be the dominant factor impacting this value/growth relationship, but they are a factor.
• Interest rates have sharply increased since the start of the year as evidenced below.

• Value stocks have significantly outpaced growth stocks since the start of the year, largely in tandem with the rise in interest rates.

• Traditional value sectors such as energy and financials have been the best performing sectors in 2021 after suffering the worst performance in 2020.
• The technology sector – dominated by growth stocks – has been the worst performing sector in 2021 after posting the highest gains in 2021.

The recent rally in value stocks is a welcome result for evidence-based investors who tilt toward value stocks because of the robust historical support for a value premium. Whether this recent value resurgence is the start of a multi-year trend or not will be eventually be determined by history but the conditions are in place for it to be a multi-year trend, regardless of what happens with interest rates. It may just be that the abrupt northbound move of interest rates this year was the catalyst needed to spark a long-awaited reversal for value stocks.