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What does the bursting of a “Bond Bubble” look like?

A lot has been made about the potential for a “bond bubble” following several successive years of interest rate falls and with interest rates now at historic lows virtually all around the world.

Even though rates are down again this year, investors have been worried for some years about what may happen when rates do eventually rise.

As a quick refresher, bond prices and interest rates are inversely related. So as rates rise, bond prices fall and vice versa. This makes sense since no one’s going to want to pay full price for a bond that yields 3% if market rates are now at 4%.
The conditions in any two investing environments are never the same, but we do have historical evidence on what has happened in the past when interest rates rose from very low levels.

From the beginning of 1950 to the end of 1981, interest rates on ten year treasuries rose by over 500%. Below you can see that rate increase along with the performance of these bonds over that period:

 

1950 Ten Year Treasury Yield: 2.3%
1981 Ten Year Treasury Yield: 14.6%
Total Bond Returns 1950-1981: 144.3%
Annual Bond Returns 1950-1981: 2.8%

Source: Robert Shiller Data

 

Investors didn’t make a whole lot of money in bonds during this period, but they didn’t get completely slaughtered either. The worst annual return for bonds from 1950 to 1981 was -5%. That kind of movement can be seen in a single terrible day on the stock market.

What many investors fail to realise when they call it a “bond bubble” is that even the worst bear market in bonds is completely different to even a run-of-the-mill correction in equities. Bond bear markets tend to be more like a death by a thousand cuts, rather than a rapid collapse.

Investors should really be worried more about “inflation risk” than “interest rate risk” when considerring their bonds. Let’s look at what happened to the bond performance over that period once you take into account the inflation rate:

 

Annual Rate of Inflation 1950 -1981: 4.3%
Real Annual Bond Returns 1950-1981: -1.4%
Real total Bond Returns 1950-1981: -37.4%

Source: Robert Shiller Data

 

The “real returns” (ie returns adjusted for inflation) paint an entirely different picture as purchasing power was slowly eroded over time in bonds in an inflationary environment.

This isn’t anything new. Over multi-decade time horizons bonds have never really been the most consistent way to beat the rate of inflation. They pay you a fixed amount of income, so as inflation rises you are getting paid less and less from a purchasing power perspective.

 

So does this mean you should dump all of your bonds for fear of a rise in rates or inflation?

 

Not if you’ve determined that they fit within your risk profile and asset allocation plans. If you just sat on bonds from now through the next few decades will you be happy with your performance? Probably not. But if you use them as a source of stability and for rebalancing purposes then yes, bonds still have a place in a well-diversified portfolio.

Bonds were not a great long-term investment in this 30+ year period (1950 – 1981) of rising rates and inflation. That’s obvious. But bonds did their part when stocks went down. When stocks fell 11% in 1957, bonds were up nearly 7%. In 1966 when stocks fell almost 10%, bonds were up 3%. And when stocks fell 37% from the start of 1973 through the end of 1974, bonds were up nearly 6% in total.

In a diversified portfolio you use your bonds to buy stocks when the stock market falls (ie you sell bonds and buy stocks). In that way bonds act as your “dry powder” during stock market sell-offs in the same way that you should harvest stock gains into bond funds when stocks are in a bull market.

Recent years have seen very strong returns in global bonds. This won’t be possible in the years ahead as rates simply can’t fall too much further. The returns will be much lower going forward . But bonds can still play a role in your portfolio with the correct perspective, plan and expectations.