Wednesday, March 21, 2012

The Coming Bear Market for Bonds?

Treasury Bond Yields

When I first started in the investment business 30 years ago, in 1981, bonds had been in a secular bear market for more than 35 years.

As you can see on the chart above, for most of the 1940's bond yields were around the 2% level.  Investment wisdom of the day called for most, if not all, of a typical investment portfolio to be invested in high quality bonds, regardless of the time horizon.

In a way, this was not surprising. Stock market returns had been disappointing for most of the 1930's and 1940's, to put it mildly.  Indeed, a survey done in 1948 indicated that more than 80% of those surveyed felt that investing in common stocks was too risky for the average person.

Bond yields started to gradually move higher in the 1950's, as economic conditions improved and credit demands increased.  However, as inflationary pressures built in the late 1960's, interest rates started to move sharply higher. 

For most of the 1970's, bonds were "certificates of confiscation" since the yields they offered did not keep pace with the high rates of inflation sweeping through the US at the time.  "Real" returns - that is, yields after deducting inflation - were negative for bond investors.

If memory serves, 1981 was the first time that bond investors lost money on a total return basis (i.e. the total capital loss was greater than income received). By 1982, the benchmark Treasury bonds sported a 14% coupon - and traded at a significant discount to par.

As it turned out, of course, early 1982 marked the peak of interest rates in the 20th century.  Bond yields gradually declined for the next two decades, and bond investors enjoyed equity-like returns.

An investor in long maturity Treasury bonds in 1982 earned a compound return of nearly 13% per annum for the next 17 years - a terrific return achieved just by investing in boring government bonds.

Yields have continued to decline for most of the last dozen years.  In a remarkable round trip, we now find ourselves with government bond yields back to the levels of the 1940's.

So what happens next?

It is too simplistic, I think, to simply say that the next leg for interest rates will be higher.  The Fed's announcement that it will be keeping interest rates at essentially 0% until the end of 2014 means that it will be difficult for rates to move sharply higher.

However, it is also true that very few, if any, investors over the last couple of years have ever sustained significant losses from investing in bonds.  Like investors 60 years ago, conventional wisdom still holds that bonds are a "safe" investment for those that want to gradually increase their investment portfolios.

For example, according to Merrill Lynch,  $483 billion has been added to bond mutual funds since 2008.   During the same time period, $38 billion has been pulled from equity mutual funds.

I fear that the surprise for thousands of investors this year might be the discovery that bond prices can also move lower. In particular, retail investors in bond mutual funds might find themselves with significant capital losses that cannot be avoided unless rates return to historic lows.

Moreover, I think it is very possible that small losses in bonds might lead to a massive reallocation from bonds to stocks in retirement and pension plans.  In this scenario, bond investors rapidly sell their holdings in favor of stocks, causing interest rates to rise at the same time that stock prices are rising as well.

In short, I don't believe this is the time to be complacent with positions in bonds.