Best Period for Bonds

In 1948, the Federal discount rate was 1.3%; by 1981, it was 13.4%. During this extensive period (34 years) of rising interest rates, the annualized returns for bonds was 3.83% (4.5% for 3-month T-bills), 11.00% for the S&P 500. Bond returns are based on total return figures for intermediate-term U.S. government bonds from 1948-1975 and the Barclays Aggregate Bond Index returns from 1976-2011.

 

The Federal discount rate is the rate charged to commercial U.S. banks on leans they receive from their regional Federal Reserve Bank’s lending facility, known as the discount window. Starting in 1982, the Federal discount rate began its downward spiral. By the end of 2011, the rate was 0.75%; on 5/15/2013, the rate was 0.75, the same as it was on 5/15/2012. The discount rate is set by the Federal Reserve Board of Governors every 14 days.

 

During the 30-year period ending 12/31/2011, the average annualized return of U.S. intermediate bonds was 9.0%, 4.9% for 3-month T-bills, and 11.0% for the S&P 500. While bond returns are greatly impacted by interest rate movement, stocks are largely immune—their returns are affected by a number of things, including interest rate changes.

 

Given this historical perspective, the question is whether or not government bonds should be considered if interest rates are expected to rise (some time after May 2013).

 

Importance of Bond Diversification

If a portfolio was solely comprised of U.S. intermediate government bonds from 1948-1975 and the Barclays Aggregate Bond Index from 1976-2011, annualized returns averaged 3.83%; a 60/40 mix (60% S&P 500 and 40% bonds) averaged 8.52% over the same period. Different portfolios and different time periods are covered in the table below [note: portfolios were rebalanced annually]. As you can see, broad diversification has paid off, usually with a higher level of volatility.

 

Asset Allocation During Rising and Falling Interest Rates

 

Portfolio	Period of Rising Rates  [34 Years, 1948-1981]	Period of Falling Rates  [30 Years, 1982-2011]
100% U.S. Gov’t Bonds [medium term]	3.8% annualized return 4.3% standard deviation	9.0% annualized return 7.1% standard deviation
60% S&P 500                40% U.S. Gov’t Bonds	8.5% annualized return 10.5% standard deviation	10.5% annualized return 11.5% standard deviation
40% S&P 500                20% Small U.S. Stocks 30% U.S. Gov’t Bonds 10% Cash	9.5% annualized return 11.8% standard deviation	10.0% annualized return 11.2% standard deviation