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Thursday, October 6, 2016 6:34
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DOUG By Guest Blogger Doug Rowat

Bond returns have been falling for decades. Here’s the proof (I use the US bond market to illustrate as it’s the world’s largest and has the best long-term data):

US Bond Returns By Decade
Source: Turner Investments, Bloomberg

Bond yields, of course, have also been falling for decades. We’ve long been taught that as bond yields fall, bond prices rise. So yields declining for decades is good, right? Not for long-term investors. The problem is that bonds regularly mature and if you’re constantly reinvesting funds from maturing bonds into newer bonds offering a lower yield to maturity, naturally, your expected return is going to steadily diminish over time. Thus the chart above.

An intriguing question becomes why have yields (and hence returns) consistently fallen for so long? Sometimes the explanation is cultural combined with comparatively unattractive alternatives. The Japanese, for instance, have always been strongly encouraged to buy domestic bonds and the long-term returns of Japanese equity markets have been dismal—the Nikkei 225 has lost about 1% per year over the past 25 years. The Japanese therefore have been more receptive to lower bond yields. But still, this explanation doesn’t apply to most other parts of the world.

Actually, the main cause of the ever-diminishing bond market returns is central banks. Their continuous slashing of interest rates has driven bond yields to the basement. But central bank action must itself have an underlying cause. Drilling deeper, slowing global economic growth likely explains central banks’ how-low-can-we-go interest rate policies. Like central bank benchmark interest rates, global GDP growth has similarly trended lower over the decades. For instance, in the 1960s it was not uncommon to have a 5–6% annual growth rate. Now we’re going to be lucky to get half that. But moving ever closer to the lowest common denominator, what then explains the declining economic growth?

You guessed it: demographics. Underlying it all—slower economic growth, lower central bank rates and weaker bond returns—is simply old age. The world, particularly the developed world, is aging rapidly and as we age, like it or not, our productivity and consumption declines. What makes it worse for bondholders is that as we age our risk aversion also increases. Simply put, when we get older we want bonds more. The chart below, which shows the increase in average US worker age versus the declining yield on US 10-year Treasuries, illustrates this relationship perfectly:

Demographics Have Driven Bond Yields Lower


Source: Turner Investments, Bloomberg

It’s hard to see this relationship changing. The United Nations estimates that the number of older people (60 years or over) globally will double by 2050 to more than 2 billion. Therefore, long term, bond yields and overall bond returns, are destined to decline further. With so many Methuselahs in the world all chasing safer returns is it any wonder that the global bond market topped US$100 trillion (with a “t”) for the first time in 2013? And with so much demand, governments certainly don’t need to offer much in terms of yield. In many parts of the world bond yields aren’t even covering the inflation rate, so real returns are negative. And in some countries, such as Japan and Germany, yields for certain maturities are outright negative.

So with this dismal backdrop, why bother holding bonds at all? Well, there’s a case to be made for going 100% equities. Former chief economist at Sanford C. Bernstein and New York Times contributor David Levine compellingly makes that case here. However, I don’t agree, mainly because the average Joe can’t keep his or her you-know-what together when equity markets are melting down. Another highly respected market historian and economist, Peter Bernstein, explained the importance of bonds by highlighting his—and, by extension, our—basic human nature when faced with market volatility:

When [equity markets] are cascading downward, keeping one’s cool is almost impossible…. Even if we could imagine a person blessed with sufficient longevity to have been active in the market ever since 1925, how likely would it be that even the most experienced and sophisticated investor would have the self-control to stay 100 percent in stocks, without trading in and out as the market rode up and down its roller coaster? I know I could not have been so calm through depressions, inflations, banking and currency crises, wars and political disruptions.

So bonds give you very little in terms of return, but a great deal in terms of peace of mind. They stabilize your portfolio and therefore stabilize YOU, preventing you from making rash decisions out of fear.

If you want to read this blog on Saturdays, you have to learn to love charts, so here’s one more. It shows the difference in volatility been the US equity market and a broad US bond index over the past 10 years:

Rolling Standard Deviation: US Equities Versus US Bonds


Source: Turner Investments, Bloomberg.

Standard deviation measures the amount of variation or dispersion within a particular index. In other words, it measures the risk of owning that index.
Think of it as a heart monitor: if you held an equity-only portfolio during the credit crisis, you, like many investors, might have sold at the worst possible moment out of fear. And if you didn’t? Good for you, but you probably now have a pacemaker because your heart exploded.

You need bonds in your portfolio. They’re uninspiring and don’t offer much, but they generally keep you safe and thinking more clearly. Basically, they’re your portfolio’s Hillary Clinton.

Doug Rowat,FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.


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