Bonds Aren’t As Safe As You Think

And the drawdown can last decades.

March 31, 2011

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net with holeIn the shorter term – let’s call it 10 years – bonds have outperformed stocks, in some countries by substantial margins. That’s one finding from the annual Credit Suisse Global Investment Yearbook. Of course, most asset managers knew that to the depth of the bones.

The Global Investment Yearbook, is compiled annually by Elroy Dimson, Paul Marsh and Mike Staunton, from the  London Business School, authors of Triumph of the Optimists, the book that began tracking long-term financial market returns across the globe, instead of just the U.S.

In this year’s update, they write an article whose focus is bonds and equities and risk premia over the long term, and over the past decade. Over the long term, there has been an equity risk premium of 3.8% over bonds – and the long term here is 111 years, for the 19 countries that constitute 90% of the value of equity markets. The last decade has seen a negative equity risk premium – 3.2%.

It gets worse, from the equity side, at least. “for the USA, over the period from the start of 1980 to the end of 2010, the annualized real (inflation adjusted) return on government bonds was 6.0%, broadly matching the 6.3% long-term performance of equities. Over the preceding 80 years, US government bonds had provided an annualized real return of only 0.2%.

“Similarly, for the UK, from 1980 to 2010 the annualized real return on government bonds was 6.3%. Over the preceding 80 years, UK government bonds had provided an annualized real return of just –0.5%. While equities have disappointed in recent times, bonds have exceeded most investors’ expectations.”

So after 20 years with bonds running almost neck to neck with stocks, naturally investors fear the worst: the end of the great bond bull. At some point, the market interest rate will rise, and existing bond values will fall. But the worst isn’t necessarily a temporary decline in bond values.

It’s the duration of that decline. Stock drawdowns have become familiar to most investors. After all, U.S. stocks still haven’t recovered from the tech melt-down of 2000. And Japanese stocks have been underwater for 20 years. In historical terms, it took U.S. stocks almost 25 years to recover from the Great Crash of 1929. What about bonds?

“The scope for deep and protracted losses from stocks makes fixed-income investing look, to some, like a superior alternative,” say Dimson, Marsh and Staunton. “But how well do bonds protect an investor’s wealth? … For those who are seeking safety of real returns … [h]istorically, bond market drawdowns have been larger and/or longer than for equities.”

Looking at the last U.S. bear market in bonds, they note, that bonds, “started from a peak on December 1940, followed by a decline in real value of 67%; the recovery took from September 1981 to September 1991. The US bond market’s drawdown, in real terms, lasted for over 50 years.”

Where does that leave bonds, not as a liability-driven piece, but as an investment? As always, the answer is diversification, at least in historical retrospect.

“While a 50:50 equity/bond blend has had a lower expected return than an all-equity portfolio, it has also had a lower volatility. Since 1900, the standard deviation of real equity returns has been 20.3% in the USA and 20.0% in the UK, as compared to bonds which has a standard deviation of 10.2% in the USA and 13.7% in the UK. For the blend portfolio, the standard deviation was attractively low: 11.7% in the US and 14.4% in the UK.

“There is nothing special about a 50:50 asset mix and, in reality, investors should diversify across more assets than just local stocks and bonds. However, this example serves to highlight the risk-reducing potential of a balanced portfolio of bonds and stocks.”

With data series, what we get is what has happened, not what will happen. All the more reason for more risk management – and debate about what is a “safe” investment.

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