Almost everyone fails the investment literacy test
By Marc Hubert
The Little-Known Relationship Between Bonds, Interest Rates, and Inflation
Ready for today’s retirement investing quiz?
Which of the main asset classes is the most correlated to inflation, the best performers when inflation is high and the worst when it is lower?
I bet you answered gold, or maybe commodities in general. And you’re not wrong, you focus on the correlation of short-term movements. This is illustrated by the attached graph, which plots the correlation coefficient between inflation and equities, treasury bills (medium and long term), commodities (according to the S&P GSCI index) and the ‘gold.
Note, however, that when you focus on multi-year time frames – as retirees and near-retirees must do when planning for retirement – the answer changes dramatically. In fact, if we focus on all the rolling 10- or 20-year periods since 1970, medium-term Treasury bills have the strongest correlation with inflation.
Hardly anyone I give this pop quiz to is successful.
How can intermediate Treasuries have this counter-intuitive relationship with inflation? There are two parts to the answer, one on how the bond market works and the other on the importance of the time horizon when developing your financial plan.
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Why Bonds Are Correlated to Longer-Term Inflation
In the short term, of course, higher inflation is bad for bonds as interest rates rise. We’ve seen it in spades over the past year as inflation has warmed to levels not seen since the early 1980s: the Bloomberg Global Aggregate Total Return Index (a benchmark representing the global investment grade bond market) last week entered a bearish market for the first time in at least 30 years.
What relatively few investors appreciate, however, is that bond portfolios gradually regain lost ground over time. This is because they are able to reinvest the proceeds of any maturing bonds into new, higher yielding bonds. If you hold out long enough, the return on your bond portfolio will almost match the higher interest rates that initially caused so much loss.
The required duration is a function of the average duration of the bonds you own, with longer duration bonds taking longer to recover in the face of higher inflation. This is why, in the attached chart, medium-term treasury bills have a higher correlation with inflation than long-term treasury bills. If I had expanded the duration of the rolling periods that the chart focuses on, the correlation of long-term Treasuries with inflation would increase to match that of medium-term Treasuries. (I couldn’t expand the chart this way, however, because with only 50 years of data, there aren’t enough rolling 30- or 40-year periods.)
Consider the performance of medium-term Treasuries during the period of high inflation of the late 1960s and 1970s. In the imagination of Wall Street, this era was one of the worst in US history. United for bonds. But in fact, it was not as terrible as our imagination tells us, at least for medium-term Treasuries. From the mid-1960s to the late 1970s, when 10-year inflation rose from an annualized rate of 1.7% to 7.4%, the 10-year yield on mid-to-mid- term went from 3.1% annualized to 7.0%.
The investment implication: Provided your investment horizon is one or two decades and you are not investing in bonds with maturities longer than medium-term, you can be relatively indifferent to the evolution of inflation and very short-term interest rates.
What about stocks? The same conclusion applies to equities, with one important caveat: your investment horizon needs to be very long before you can be indifferent to inflation and interest rates.
How long? As an answer, I refer you to a column from a month ago in which I discussed research that found this required time to be over 40 (!) years. It’s a sobering finding, because few of us have such a long investment time horizon, even if we haven’t entered retirement yet. This, in turn, means that when it comes to our equity portfolios, we cannot really be indifferent to bear markets that may arise along the way, despite constant reassurances from financial planners around the world that the long term we will save.
It is a reflection of the greater risk of stocks that this required holding period is so long. The higher long-term inflation-adjusted return of equities is a compensation for their greater risk. In fact, of all the major asset classes, equities come out on top over very long time horizons. But to realize this higher return, you have to bear this greater risk.
This is another reason why bonds continue to play an important role in our retirement portfolio. By creating a diversified portfolio that includes both stocks and bonds, you can reduce the amount of time it takes to be indifferent to bear markets down the road.
In summary: if possible, bonds are even more neglected than equities at the moment. But a sober examination of history suggests that they continue to have a role to play in our wallets.
Mark Hulbert is a regular MarketWatch contributor. His Hulbert Ratings tracks investment newsletters that pay a fixed fee to be audited. He can be contacted at [email protected]
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