It is no wonder that so many long-term bond auctions are turning into nail-biters — not just in the US, but in Japan and Europe, too. After all, who’d buy long-term bonds? Long-term interest rates have become much less predictable, and that means volatile prices for long bonds. Even worse, the normal negative correlation between the bond and stock markets has become less of a sure thing.
Nevertheless, to answer the question: Just about everyone should buy long-term bonds. They may be the best hedge in an increasingly uncertain environment.
The rising yields reflect uncertainty in the market. Inflation is a risk again, which increases yields. Judging from US policy of the last few years, there is no longer any pretense that America cares about the national debt. That means many more bonds will be sold in the future.
Meanwhile, America’s safe-haven status is unclear as it steps back from global market and aims to reduce its current account deficit. The US will be issuing more debt, but it can no longer count on an unlimited number of captive buyers. Rising long-term rates reflect this risky future. And it is not just the US: The whole world is more uncertain, with more decoupling and many rich countries issuing more debt to pay to care for their aging populations. Even Japan is now facing market prices and high yields.
All these risks mean higher rates on the long end of the yield curve. And don’t look to the Federal Reserve for relief: Its tools have more influence on short-term debt. Even if yields don’t go much higher than 5% — a big if — there will more volatility, which means bigger swings in price, especially for longer duration assets. There is also less value in diversifying from buying long bonds with stocks, since their negative correlation is no longer something you can count on.
Short duration bonds are tempting: Sure, the yield is lower, but there is the price certainty investors expect from bonds. But it would be a mistake to surrender to the siren call of Treasury bills. Most people are already short duration in their portfolios — what they need are longer duration bonds.
The tumult in the bond market requires clarity about the goals of investing, and that means seeing bonds as a hedge rather than a way to diversify. Too many investors confuse these strategies. Diversification means owning a lot of assets that aren’t perfectly correlated, or constructing an efficient portfolio that delivers a higher return with less risk. Diversification can mean owning bonds (of different credit quality), global stocks and even commodities, if that’s your thing.
Hedging means balancing your risky (well diversified) portfolio with something that is risk-free (or very low risk). You give up some return in exchange for more certainty. This could lead you to a short-duration bond, because its price is pretty stable and it does not lock up your money for very long. A longer duration bond (at least a US Treasury) can also be sold fairly easily, so it is liquid too, but its more volatile price makes it riskier.
But if safety is what you require, that price volatility may be just what you need. Most people are saving for the long term — retirement may be a decade or more away. Say you finance your retirement with a 20-year-coupon bond or an annuity when you retire. The price of your future retirement is just as volatile as a long-term bond, because it also based on long-term interest rates. If you invest in a short-term bond, you are not ensuring you can still spend a stable amount several years from now. The figure below is the price change, month to month, of a 20-year zero-coupon bond, a 30-year annuity, and a three-month Treasury bill. The price of the bond and the annuity move pretty much together, while the T-bill offers very little protection.
Short-term debt looks even riskier once inflation is taken into account. The risk-free asset for future retirees is actually an inflation-indexed long-term Treasury, though at least a nominal bond has some compensation for inflation risk by offering a higher yield. Long-term debt should also be in the portfolios of many governments, which are big bond buyers, to help them finance their pension obligations.
And yet a flight to safety is starting as a flight to short-duration bonds. When yields were low and stable, bonds could be used as both a hedge and as a diversification strategy. There is also a tendency to judge performance by asset balance, and short-duration bills are more stable.
But the purpose of saving in the present is to enable spending in the future. That saving should also offer some protection from both inflation and swings in rates. The conclusion is practically inescapable: Everyone should own more long bonds.
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