Grim as things seem, most of us are in better shape than we’d be in a higher rate environment. Before inquiring about the strength of the product purchased from my local cannabis outlet, let me explain.
In 1873, Walter Bagehot famously wrote, “John Bull can stand many things, but he cannot stand two percent.” In other words, when the yield on consols – perpetual British government bonds – fell to that intolerably low level, frustrated investors sought out more speculative securities sporting higher yields, to their eventual regret. (More than a century later, Legg Mason analyst Raymond DeVoe would offer a more pungent assessment: “More money has been lost reaching for yield than at the point of a gun.”)
At the times of both those assessments, safe bonds yielded, well, 2% real returns, a rate that is a delicious distant memory. Today’s real rate of return of government securities, as judged by the TIPS yield, runs from -1.74% at five years to -0.35% at 30 years. The retiree who relies on a ladder of them – until now, the gold-standard method of defeasing a steady stream of liabilities – will suffer a slow, steady erosion of their spending power, likely until the day they die.
Throughout the land the cry is heard, “Where can I go for yield?”
The swift and brutal answer to this question is, of course, “nowhere”: One can reach for yield by taking credit or duration risk, and likely suffer the grim fate foretold by Bagehot and DeVoe, or else monetize one’s mortality with an annuity, thus sacrificing command of the assets and risking the possibility of pushing up the daisies quickly enough to lose most of the corpus.
I say, don’t worry, be happy.
Consider the counterfactual of historically “normal” interest rates. In such an environment, equities would surely be selling at much lower prices. How much lower? Consider this plot of the Shiller CAPE versus the10-year Treasury over the past 15 years:
Cast your gaze to the right side of the graph, and you’ll see that at 10-year yields of around 4%, CAPE ratios average in the mid-20s; as this is being written, it is just shy of 40: look out below! Will Treasury rates ever rise again to that level? Beats me, and besides, that’s not the point, which is to be careful what you wish for; to the extent that your portfolio is exposed to equities, you have far more assets than you’d have at higher bond yields.
The choice then, is between a big portfolio with a lousy yield, or a much smaller portfolio with better yields. This iron logic makes two points. First and most important, it clarifies which retirees have been hurt by low yields: those who have been overly conservatively invested the past three decades, and so have not benefited from the Federal Reserve-derived asset bloat. On the other hand, the retiree who has hewn to anything even close to the much-derided 60/40 conventional wisdom are now sitting on far more assets than they deserve to have.
Second, given the large portfolio-lousy yield/small portfolio-high yield choice, which would you prefer? It depends on who you are. As already hinted above, retirees with conventional balanced portfolios are sitting pretty, especially if rates remain low and stock valuations remain high; it is likely, for example, that flush 401(k) participants are a significant and unremarked cause of the current post-COVID labor shortage. And if stock valuations collapse, they’re going to feel a whole lot better about their T-bills with microscopic yields.
On the other hand, low rates and high valuations are not the friends of younger savers – yet one more source of anti-boomer resentment by their millennial children, who are currently paying inflated prices for their nest eggs. The best that they can hope for is higher bond yields and consequently collapsed equity prices, and the sooner, the better.
All great economic shifts, from globalization to the rise of the service economy and information technology, produce winners and losers. In this case, the global financial crisis of 2007–2009 and the COVID pandemic resulted in a one-two punch of swollen central bank balance sheets that have driven interest rates to, and in a few cases, below, the zero lower bound, which in turn has yielded one of history’s most powerful equity bull markets. The winners are the owners of those equities, who can retire in greater comfort and security, and the losers are retirees with predominantly fixed-income assets, who cannot, and young savers, who, barring a significant reversal of the current low-yield regime, must work longer and save more.
William J. Bernstein is a neurologist, co-founder of Efficient Frontier Advisors, an investment management firm, and has written several titles on finance and economic history. He has contributed to the peer-reviewed finance literature and has written for several national publications, including Money Magazine and The Wall Street Journal. He has produced several finance titles, and four volumes of history, The Birth of Plenty, A Splendid Exchange, Masters of the Word, and The Delusions of Crowds about, respectively, the economic growth inflection of the early 19th century, the history of world trade, the effects of access to technology on human relations and politics, and financial and religious mass manias. He was also the 2017 winner of the James R. Vertin Award from CFA Institute.