For some reason, the received wisdom of the financial world is that bonds are considered safe and solid investments, while equities are considered risky. Not only do most individual investors believe this to be true — they at least have the excuse that their professional advisers told them so — but so do most investment professionals.
These professionals, when pressed, will churn out statistical analysis, based on historical price records, which prove that bonds are less risky. They will have recourse to Greek letters such as beta, delta and theta. When faced with this ineffable mix of science and jargon- based mumbo jumbo, who would be so bold as to argue?
Let us, therefore, in the seasonal spirit of goodwill, accept the claim that historically, bonds have been less risky than shares. Let’s at least allow that government bonds have been less risky than blue-chip stocks and maybe even that junk bonds have been less risky than small-cap shares. Now let’s move from history to current affairs.
As 2015 opens, the yields on short-term bonds and bills issued by the governments of several developed countries are negative. To the uninitiated, to the unsuspecting and to those who are just plain ignorant, let me spell out what a negative yield is. It is when you buy a debt obligation at a price that, if you hold the said obligation until maturity, you will be paid back less than you paid in. Repeat, less. As in L-E-S-S. That’s before any ancillary costs, such as commissions.
So much for theory. Now let’s review the state of the world’s debt markets:
Exhibit A: Japan. The yield on Japanese government paper is negative, not just on bills with three, six or even 12 months duration, but all the way out to two years. A five year JGB (Japanese government bond) will pay you 0.02% per annum, in yen. Not attractive? Then try a ten-year Japanese bond, the yield on which just broke its previous record low (from April 2013) and now offers 0.31% per annum. In yen! Mouth-watering, no?
Exhibit B: Germany. German government paper, known as ‘bunds’, is even more lucrative than Japan’s. A two-year bond will shave 0.12% off your investment each year, but five-year bunds offer better value: the yield is a princely zero. Buy a ten-year bund and you are guaranteed a healthy positive return of 0.54% per annum. In euro — if there is a euro in ten years’ time.
Exhibit C: United States: In America, as is well known, the streets are paved with gold — and they even pay you a positive return on your money. A 90-day T-bill, backed by the full faith and credit of Uncle Sam, was offering 0.04% as the year ended — it has been negative at various points over the last year or two, so this is heady stuff. As for 0.21% on a 12-month T-bill, that may be an offer you can’t refuse — unless you prefer medium-term bonds, such as the 1.65% yield carried by 5-year bonds or even 2.17% on 10-year Treasury. Better still, for those planning to be around for a long time, is the 2.75% yield on offer for a 30-year Treasury bond.
Now back to historical data — but only as far as 2014. In the year just ended, 30-year US government Treasury bonds gave investors a total return (interest plus capital appreciation) that was more than triple the return on the Dow Jones Industrial Average and over double that of the S&P 500 Index. In hard numbers, the ‘long bond’ returned some 25%. Even US municipal bonds — ‘munies’ — returned an average 9%, beating the Dow but not the S&P.
Why did bonds achieve such high returns and why are their yields currently so low? Because they were being bought, intensively. However, it is not true to say that “there were more buyers than sellers”, because there were actually not many buyers. In Japan, there was precisely one buyer but, since its name is the Bank of Japan, and its policy is to buy more bonds than the government issues to finance its gigantic budget deficit, that one buyer outweighs all the sellers put together.
In Europe it is not yet that bad, while in the US the Federal Reserve has wound own its bond-buying program. There are more buyers there, because people believe that interest rates will stay low, or go even lower, over the next year or two or even longer.
Nevertheless, the bond market is extremely risky — the discussion here has focused on government bonds, but the financial situation of many corporations and municipalities is shaky to say the least and the yields on their bonds have been rising since mid-year.
Agreeing in advance to get no return, or to accept a very low return for a high level of risk, is not something that professional investment advisers are supposed to urge their clients to do. Why, then, are they telling clients to buy bonds, or even to continue to hold the bulk of their portfolio in bonds? Ask ‘em.
Originally published on January 2nd.