Are Bonds Becoming Obsolete?

Currently, we are sitting at an all time low interest rate environment where many sovereign rates sit in negative territory (approx. $10 trillion in negative-yielding debt). This interest rate climate leaves people wondering where the bottom is and whether the standard “60/40” equity to bond allocation is still viable. I am going to explore the current environment and why bonds have become less attractive for investors and where we can go to achieve higher returns and diversification.

the 700-Years of Declining Interest Rates

Paul Schmelzing, visiting scholar at the Bank of England shows how global real interest rates have experienced an average annual decline of -0.0196% (-1.96 basis points) throughout the past eight centuries and may be here to stay.Source: Bank of Eng… — Paul Schmelzing, visiting scholar at the Bank of England shows how global real interest rates have experienced an average annual decline of -0.0196% (-1.96 basis points) throughout the past eight centuries and may be here to stay.
Source: Bank of England Staff Working Paper No. 845, *Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018*, Paul Schmelzing.

In a working paper for the Bank of England, Mr. Schmelzing identifies three main causes for the decline: (1) slowing productivity growth which results in lower demand for capital, (2) slowing economic growth from secular stagnation, and (3) an aging population resulting in lower labor force participation. Read his paper here. I would argue that in the last 100 years increased competition, transparency, and monetary policy within the economy and financial sectors have helped push and keep rates down. Through improved regulation, information availability, and technological advancement, transparency in markets is at an all time high. This increased transparency has ultimately led to increased competition in the lending space and drives rates down further.

Nominal bond yields (GDP and arithmetically-weighted), 1314-2018

All-time GDP-weighted real rate average at 6.32%. All-time Decrease in in global real interest rate of -1.59 bps p.a.Source: Bank of England Staff Working Paper No. 845, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decl… — All-time GDP-weighted real rate average at 6.32%. All-time Decrease in in global real interest rate of -1.59 bps p.a.
Source: Bank of England Staff Working Paper No. 845, *Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018*, Paul Schmelzing.

Global inflation (GDP and arithmetically-weighted), 1314-2018

Inflation levels on the global basis exhibit similar behavior to that of the “safe asset provider” (key identifier are the frequent “deflationary dips”). During the most recent 200 years (1818-2018), global inflation averaged ~2.5%.Source: Bank of E… — Inflation levels on the global basis exhibit similar behavior to that of the “safe asset provider” (key identifier are the frequent “deflationary dips”). During the most recent 200 years (1818-2018), global inflation averaged ~2.5%.
Source: Bank of England Staff Working Paper No. 845, *Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018*, Paul Schmelzing.

The key takeaway the two graphs above is that returns from bonds are now barely enough to combat inflation and larger societal factors and trends have led to the gradual decline in interest rates. Currently, the S&P 500 having a dividend yield at around 1.8%, the risk to reward or Sharpe ratio in comparison (Sharpe ratio for S&P 500 at 1.0 vs high yield bond funds: 0.8 - JNK, 0.87 - HYG) makes bond allocation in the vast majority of portfolios seem obsolete.

Rethinking Portfolio Allocations

Now that we’ve established the context behind the current low interest rate environment, what does that mean for an investor today? I would argue that because of the nature of the current environment, lower interest rates are here to stay. For investors and portfolio managers, especially those with longer time tables, the old “60/40” allocation model is outdated and won’t produce enough returns to support the vast majority of individual’s investment and retirement needs. I believe that these portfolios are underweight equities and that the new standard allocation should be closer to “75/25”. Nonetheless, diversification and risk management are still critical for successful investing.

Sources: SEC Filings and www.bdcbuzz.com

New High Yield Dividend Stocks

While searching for returns like a bond but with much higher yields, I came across Business Development Companies (BDCs). BDCs were created by Congress in the 80s to give investors incentives to invest in smaller and mid-sized U.S. companies often overlooked by larger banks and investment firms. BDCs must be registered in compliance with Section 54 of the Investment Company Act of 1940. Read more at Investopedia. BDCs are also required to have at least 70% of their assets invested in private or public U.S. firms with market values of less than $250 million. Additionally, BDCs are regulated investment companies (RICs) which means they must distribute over 90% of their profits to shareholders. That RIC status means they don't pay corporate income tax on profits, allowing them to pass along income directly to the shareholder. This dividend payout from BDCs is similar to a bond’s coupon and with correct risk mitigation and diversification can generate stable cash flow. BDCs are averaging annual yields of almost 10% (S&P averages return is 8% and High Yield Bonds are around 5%) and are become increasingly attractive in retirement portfolios.

Potential BDC Investment risks

Such exceptional returns aren’t without risk. One of the main risks is that although a BDC itself is liquid, many of its holdings are not. The majority of a BDC’s holdings are smaller publicly traded companies and private firms which presents liquidity risk. Additionally, BDCs often employ leverage (borrow money to invest or loan to their target companies) which can improve rate of return on investment (ROI), but it can also mean magnified losses if investments have negative returns which is further exasperated by the illiquid nature of their business. Heavy leverage can also cause cash-flow problems if the leveraged asset declines in value and means that interest rate risk is an important factor to consider. A rise in interest rates would make it more expensive to borrow funds and hurt the BDC's profit margins. This is why Mr. Schmelzing’s research is a key to understanding why BDCs are so attractive now—low interest rates are here to stay.

Keys to Being a good BDC investor:

Here are some key considerations you need to take to be a responsible BDC investor:

As companies report results, monitor dividend coverage potential and portfolio credit quality (leverage/interest rate risk)
Identify BDCs that fit your risk profile (high returns aren’t without its risk, there’s no such thing as free money)
Establish appropriate price targets based on relative risk and returns (mostly from regular and potential special dividends)
Diversify your BDC portfolio with at least five companies (There are around 50 publicly traded BDCs, be selective)

Ultimately, when constructing a portfolio for long term growth it’s important to consider the ever changing environment and trends to make smart investment decisions and grow your assets. Diversification and proper due diligence are nevertheless still paramount to successful investing! What do you think about bonds, BDCs, and investing in general? Share your ideas with me!

About the Author