(MoneyWatch) Word has it that interest rates, which recently ticked up, are near historic lows and must go up. We all seem to accept this as the "truth," but is it really?
At the time of this writing, the 10-year Treasury bond was yielding 2.65 percent annually. An investor in the 28% tax bracket would get an after-tax yield of 1.91 percent. If the Fed hits the two percent target for inflation, a 2.0% CPIU, then the real after-tax yield is a negative 0.09%. This means the investor has slightly less spending power after a year.
As bad as this seems, let's go back to 1980 for a little perspective. Most people have rosy, revisionist memories of 1980 as good investing times with high rates for investors. In fact, the 10-year Treasury was yielding an average of 12.0 percent that year. Thus, at the same 28% tax bracket, that amounted to an 8.64 percent after-tax yield. Yes, rates were high, but so was inflation. It was a veritable runaway train, during which time the CPIU rose 13.50 percent. So the real, after inflation, yield back then was a -4.28 percent, or more than four percentage points worse than today. After a year, one could buy 4.28 percent fewer goods after earning this high yield and paying taxes on it.
Framing the argument by rates alone, it's easy to see how investors could view 1980 as a good time to own bonds and CDs, and today as being, well, a not so good time. That's because we think in nominal terms when we should be thinking in real terms. After all, money allows us to buy things, and if we can buy fewer goods and services, we've had a negative return.
What this means for the future
On the one hand there are the experts who nearly universally agree that interest rates must go up, and on the other hand there is the track record for such predictions, which is somewhere below randomness.
We know that bonds can't continue the bull market that's been going on for a few years. The Vanguard Total Bond Market ETF (BND) has earned 5.16% annually over the past five years. For it to turn in such a performance over the next five years, rates would have to turn negative on a nominal basis. That is to say the investor would have to be willing to lend $100 for the promise to get back $99 in the future. This is isn't going to happen.
It also doesn't mean that it's imminent that rates will go up. Though I keep hearing that bonds are as risky as stocks and should be avoided at all costs, I personally think that this is just another excuse to chase performance.
Interest rates may go up, stay low, or even tick lower. Bond funds and CDs are the largest part of my portfolio. If rates do go up and my bonds decline in price, I'll rebalance and buy more fixed income.