Bond funds have generally been on a total return “tear” the past several years, given the sharp decline in U.S. Treasury yields.

Bond fund cash flows have been solid, especially into corporate and municipal bond funds, which tend to carry a higher yield than a similar-maturity Treasury bond fund. Unfortunately, strong trailing returns and strong cash flow haven’t always coincided with strong future returns. All one needs to recall is equities in the late 1990s.

Today, I worry the prolonged low rates could distort the investment choices we all make, especially when looking for income. The Fed’s zero-percent interest rate policy is effectively a “tax” on savers. Are savers moving from money market funds to bond funds? Are investors selling bond funds to buy dividend-paying stocks? It appears so. And I worry whether we all have reasonable expectations for what bond returns (and their volatilities) may look like going forward.

The likely end of the U.S. bond bull market

Naturally, the heady bond returns realized over the past several years are unlikely to repeat any time soon given the present level of interest rates. Arguably the single best predictor of the future return on a bond portfolio is its current yield to maturity or coupon. As such, the long-run return profile for broad bond portfolios is muted and most closely resembles the historical bond returns of the 1950s and 1960s.

And, yes, there is the elevated risk that bonds in general (and Treasury bonds in particular) may post negative returns at some point over the next several years given the low coupon or income cushion in their portfolios and the bond market’s expectations for higher rates. This latter point is far from certain, since Treasury yields tend to “random walk.” Meaning that Treasury yields don’t necessarily mean-revert, but rather tend to drift in unpredictable ways. Remember when all the market pundits said the 10-year Treasury “had” to rise last year when its yield was 3%?

Nevertheless, some prominent figures have commented recently that investors should seriously rethink and reallocate their bond portfolio in this current low-yield environment.

Sell my Treasuries for higher-yielding alternatives?

Some have said that Treasury bonds are a “sucker’s bet,” with the assumption that rates have nowhere to go but up (see my comments above for my thoughts on that). Some even recommend replacing all bonds with stocks. I suppose they’ve forgotten the importance of strategic asset allocation in dictating a portfolio’s return patterns over time.

A less-radical suggestion by others (including Vanguard’s founder, Jack Bogle) is to replace paltry-yielding Treasuries with corporate bonds in a fixed income portfolio. This is where it gets tricky, folks, because it’s all about your preferences of risk and return, your investment objectives, and how much stock exposure you have in your broader portfolio. In my view, Jack’s suggestion runs the risk of forgoing too much flight-to-quality benefits for too little extra return.

To be clear, Treasury bonds presently have a poorer absolute return outlook than higher-yielding corporate or municipal bonds. But they should, since the higher yields on those other bond investments are the (expected) compensation for bearing risks beyond interest-rate risk. This is nothing new. But for even higher annual returns of, say, 4% or more? I have stocks in my portfolio for that.

Treasury bonds as shock absorbers

Regardless of the direction of U.S. interest rates, I am sticking to my overall bond allocation, including Treasury bonds, too, despite their paltry yields. This isn’t based on patriotism or inertia (although I am prone to both).

It’s simply the belief that you can’t have a truly diversified balanced portfolio without having explicit Treasury exposure.

Personally, I hold Treasury bonds not for their absolute returns, but for their powerful flight-to-quality diversification properties. I’m happy I maintained my diversified bond portfolio last year, when global stock markets fell and corporate bonds underperformed Treasuries. Despite claims from some that low-yielding Treasuries are no longer a viable portfolio diversifier, long-term Treasury bonds were again one of the stars last year in a period of stock-market stress. It could happen again, although I hope not.

But what if U.S. interest rates rise a lot, as in the 1970s and early 1980s?

Should U.S. interest rate rise dramatically at some point over the next several years, the immediate losses and volatility of Treasury bonds wouldn’t be pleasant. But I try to remind myself every time I look at my portfolio that over the long term, it’s interest income—and the reinvestment of that income—that accounts for the largest portion of total returns for many bond funds. The impact of price fluctuations can potentially be offset by staying invested and reinvesting income, even if the future is similar to the rising-rate environment of the late 1970s and early 1980s.

During this period, the yield on the 10-year Treasury bond nearly doubled, rising from approximately 8.0% in December 1975 to as high as 15.3% in September 1981. At the end of 1983, the 10-year Treasury yield remained in double-digits, standing at 11.8%. Yet a hypothetical $10,000 investment (with all investment income reinvested) in the Barclays’ Capital U.S. Aggregate Bond Index (the benchmark for the Vanguard Total Bond Market Index) made on December 31st, 1975 would have increased to over $13,500 by September 1981 and would have actually doubled to $20,000 by the end of 1983—not necessarily a disastrous outcome given the period’s secular rise in interest rates. Moreover, the high interest rates in the early 1980s subsequently fell as inflation expectations declined and monetary policy became more restrictive, setting the stage for even higher bond returns over the following decade.

For me, the key is staying invested and reinvesting income. That has meant periodically rebalancing my portfolio and “selling” bonds for stocks when bonds have beaten stocks, and vice versa. While I find these steps fairly simple, and suitable for me, everyone should remember to construct their portfolios based on their own financial situation. Should rates rise this year, a certain percentage of the Treasury and other bonds would mature, and those proceeds would be reinvested in higher-yielding securities.

Everything in moderation, with eyes wide open

A key lesson of the global financial crisis was that implementing a too-narrow or surgical bond allocation (e.g., shortening duration or investing solely in riskier bond instruments), involves important tradeoffs that may expose bond investors to unintended yield-curve, or market risks while potentially depriving them of a higher future income stream. The range of potential future outcomes would seem to support greater fixed income diversification in the years ahead, not less.

That means I’m sticking with Treasury bonds despite their paltry yields, and I’m fully cognizant of their muted and volatile return outlook. For that isn’t why Treasuries are in my portfolio. They’re there for when my other investments are performing poorly. That is what portfolio diversification is all about, and why I still own U.S. Treasury bonds.

And wherever interest rates go, I always will.

• All investors should carefully consider their own investment objectives, risk tolerance and time horizon before making an investment decision. Mr. Davis’s comments regarding his personal portfolio should not be construed as a specific investment recommendation.
• All investments, including a portfolio’s current and future holdings, are subject to risks, which may result in the loss of principal. Investments in bonds and bond funds are subject to interest rate, credit and inflation risk. Past performance is not a guarantee of future results.
• U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest. Although the income from the U.S. Treasury obligations held in the fund is subject to federal income tax, some or all of that income may be exempt from state and local taxes.
• Diversification does not ensure a profit or protect against a loss in a declining market.