Great post by Michael Stokes at MarketSci Blog on the impact that historically low treasury rates could have on Tactical Asset Allocation (TAA) models. A large portion of historical gains from both backtested TAA models and balanced portfolios have been from the huge increase in treasury bond values over the past 30 years as yields have fallen from a peak of over 15% to less than 2% today.
If yields were to stay relatively stable, the lack of increase in the value of treasuries combined with the low yield would significantly reduce the returns contributed by the bonds portion of a balanced portfolio. Barring any significant stock market out-peformance, this is likely to bring balanced portfolio returns down significantly from what investors have previously experienced.
A worse scenario is if yields rise rapidly and drive down the value of an investor’s existing bond portfolio. The yield would be higher but it would take years for the extra yield just to restore the loss in principle value. A large rise in treasury rates could also lead to a reduction in equity PE ratios to offset the increased rates of “risk free” returns. Meaning that investors could see simultaneous losses in both the bonds and equites portions of their portfolio.
As the saying goes – “Whenever you figure out the key to Wall Street, they change the locks”. Most investors and advisors believe the current key is to have a large bond position to provide steady and consistent income, a plan that has worked well for 30 years. What will happen to these portfolios if the bond portions begin to earn minimal returns or become money losers?