Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
This article first appeared in the Telegraph
Unless something remarkable happens in the next week or so, government bonds will soon deliver their worst quarterly performance since at least the late 1980s. The sharp rise in yields since the beginning of the year has seen US Treasury bonds with maturities of at least 10 years fall by nearly 15% in three months. Please remember past performance is not a reliable indicator of future returns.
This is a shock for investors who, over the past 40 years or so, have come to view bonds as an asset class with equity-like returns but cash-like risk. They have provided capital gains without the stock market’s stomach-lurching corrections. Four decades is a very long time for an asset class to defy the normal rules of risk and reward. But the period since the 1980s should be seen as an extended but unsustainable aberration.
There’s no secret about why bonds have started to perform so badly. The price of a bond moves inversely to its yield and this year the yield on the 10-year Treasury, the main government bond benchmark, has risen from 0.9% to 1.75%. Investors are looking at the wall of money being thrown at the pandemic by the US government, and the Federal Reserve’s determination to keep short-term interest rates low for as long as possible, and they draw an inevitable conclusion. Inflation is coming back. Not as an unfortunate consequence of bad economic policy, but as a planned and desired outcome. Inflation is seen as the solution to a mountain of debt. That scares the bond market.
It is right to be worried. Inflation is a killer for fixed income investors. It eats away at the purchasing power of your investments until, in extreme cases, like those experienced in Europe in the first half of the 20th century, there is nothing left.
If we look back beyond the golden age for bonds since the 1980s, the long run picture is a lot less exciting. Over the 121 years covered by Credit Suisse’s Investment Returns Yearbook, bonds have delivered a real, inflation-adjusted return of just 1% a year. Some of that poor performance can be ascribed to hyper-inflation in Germany and Austria, but even in the US and UK the real returns from bonds have only been around 2%. Between 1900 and 1981, the real returns from bonds were negative. It is only the exceptional and unsustainable performance of the past 40 years that drags them back into positive territory over the whole period.
Inflation is the key to understanding the ebb and flow of bond returns. There is a clear inverse correlation between bond performance and changes in prices. The poor performance of bonds in the first half of the 20th century was a consequence of high inflation during and immediately after the two world wars. In the post-war period, it was the inflationary 1970s that was to blame. Since the 1980s, investors have benefited from a series of tailwinds for bonds: Fed chairman Paul Volcker’s hard-won victory over inflation; the disinflationary impact of globalisation; the safe haven status of bonds during the bear markets of the noughties and the subsequent financial, Eurozone and Covid crises; and, most powerfully, the zero interest rate policies and quantitative easing of the past 12 years.
The past four decades have lulled us into a false sense of security. We see bonds as being safer than shares. But the reality is less clear cut. It has been possible to lose a lot of money in bonds. Even if we set aside the wipe-outs caused when a country loses a war, losses can be significant.
Between 1972 and 1974, for example, UK bonds lost half their inflation-adjusted value. Periods under water can be long and morale-sapping too. The US bond market peaked in 1940 before huge spending on the war effort and later Vietnam ignited inflation. It did not recover its previous high until 1991, a drawdown of more than 50 years. Here, the parallel decline lasted for 47 years until 1993. A US investor has only needed to hold shares for 16 years to be assured of a positive inflation-adjusted return. In bonds they might have waited as long as 57 years if they had timed their purchase really badly.
There are three reasons to hold bonds in a portfolio: a predictable income stream; the prospect of a capital gain; and because they help deliver a smoother investment journey by behaving differently than shares. On all three fronts, I suspect the future will look less good than the recent past.
Last week, Fed chair Jerome Powell re-stated his determination to support the economy and promote full employment for as long as required. Effectively that means a period of unofficial yield curve control. Interest rates will be pegged below the rate of inflation, which will be allowed to exceed the Fed’s target for an undefined time. Good luck reversing that policy. Letting the inflationary genie out of the bottle is a lot easier than stuffing it back in again.
As for the capital gain, that shipped has sailed. With interest rates as low as they are likely to go, the forward projections for real bond returns in the Credit Suisse yearbook are slightly negative as the already disappointing yield on bonds is offset and a bit more by a loss of capital. And with interest rates unable to fall any further, the opportunity for bonds to serve as a safe haven when shares are falling is reduced.
This is not a counsel of despair. The extraordinary measures being taken to support economies as we emerge from Covid represent a hugely positive set-up for some parts of the stock market, such as UK value shares. But the rising tide which lifted all boats for 40 years is now ebbing away.
Five year performance
|(%) As at
Past performance is not a reliable indicator of future returns
Source: Refinitiv, total returns in USD terms
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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