Investing in a Zero Rate Environment

September 24, 2020

In March, as the country shut down in the face of a global pandemic, the U.S. Federal Reserve dropped the Federal Funds Rate to zero in an attempt to stem the tide of economic damage the pandemic was wreaking. On September 16th, Fed Chairman Powell indicated the Federal Reserve was prepared to keep rates at zero through at least the end of 2023. Given this outlook, do bonds continue to make sense for investors in the face of these low rates?

Why Bonds Matter

Even in the face of zero interest rates, bonds are an important part of an investor’s portfolio. Bonds are a critical diversifier against equity risk. You can see that power in the first quarter of 2020, as markets crashed in the face of the Covid-19 pandemic.

Source: Ycharts

 

This diversification works in a low rate environment. In 2011, while rates were at zero and Standard and Poor’s downgraded US Government debt to AA, a market sell-off ensued. From July 1 to December 31, 2011, the S&P 500 dropped over 5%, with a drop being as big as 17.5% in early October. Meanwhile, bonds (as represented by the Bloomberg Barclays US Aggregate Index) steadily climbed and ended up a little over 5%.

Source: Ycharts

 

Why Cash is Not Always King

Facing zero interest rates, oftentimes investors are tempted to park their safe assets in cash and wait for higher yields and returns from bonds when interest rates pickup. However, this strategy typically backfires, as cash provides a much lower return. Cash investing is expressly tied to short-term rates, and when the Federal Funds rate is near zero, so is the return on cash. However, a bond investor can invest in longer-dated bonds and pick up more yield as a result, even while maintaining high credit quality. This difference compounds over time and puts the cash investor substantially behind.

For example, using the Bloomberg Barclays US Treasury Bill 1-3 Month benchmark as a proxy for cash, you can see that while low-interest rates persisted, cash investors returned almost nothing (0.08% annualized for the period October 31st, 2008 through October 31st, 2015). However, bond investors returned 3.68% per year during this same time frame. If you had invested $100,000 on October 31st, 2008 in both of these strategies, the bond investor would end up with $128,757.40, while the cash investor would end up with $100,575.90. This shows the power of compounding, even in the face of zero interest rates.

Despite the Federal Reserve’s conviction to keep rates low for the next few years, bonds still represent an important source of both diversification and return in a well-constructed portfolio. Bonds still perform their role in the portfolio of providing diversification and a bulwark against equity volatility. Disciplined investors should stay in the bond market even in the face of the expectation of a long period of low or zero interest rates.


Disclosures:

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Future performance of any investment or wealth management strategy, including those recommended by Balasa Dinverno Foltz LLC (BDF), may not be profitable, suitable for you, prove successful, or equal historical indices. Historical indices do not reflect the deduction of transaction, custodial or investment management fees, which would diminish results. Any historical index performance figures are for comparison purposes only and client account holdings will not directly correspond to any such data. BDF clients must, in writing, advise BDF of personal, financial, or investment objective changes and any restrictions desired on BDF’s services so that BDF may re-evaluate its previous recommendations and adjust its investment advisory services. BDF’s current written disclosure statement discussing advisory services and fees is available for review at www.BDFLLC.com or upon request.

Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from BDF.

The S&P 500 Index includes a representative sample of the largest 500 companies in the U.S.

The Bloomberg Barclays Capital U.S. Aggregate Index (US Aggregate) represents securities that are SEC-registered, taxable, and dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Bloomberg Barclays 1-3 Month U.S. Treasury Bill Index (the “Index”) is designed to measure the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to 1 month and less than 3 months.