The Bond Market: A Look Back
Many retail investors shun the bond market because it does not offer the same level of potential upside as the stock market. While the bond market is different from the stock market, it should not be ignored. It is comparable in size to the stock market and has enormous depth.
Triumph Of The Optimists: 101 Years Of Global Investment Returns, a 2002 book written by Elroy Dimson, Paul Marsh, and Mike Staunton, can help us review bonds in the 20th century. We will then consider the impact of innovation. Finally, we will look at bond market returns during the first two decades of the 21st century.
- Equity investors triumphed over bond investors during the 20th century.
- Long-term government bond yields declined from a high of 15% in 1981 to 6% by the end of the century, leading to higher bond prices.
- In the first decade of the 21st century, bonds surprised most observers by outperforming the stock market.
- Stocks returned to their dominant position during the second decade of the 21st century.
- For the most part, investing in fixed income during the past century was not an overly lucrative proposition.
An Unkind Century for Bond Investors
Equity investors triumphed over bond investors during the 20th century. The risk premium built into bonds during the 1900s was much too low to compensate investors for the forthcoming turmoil. This period saw two secular bear and bull markets in U.S. fixed income. Inflation peaked at the end of the First and Second World Wars as a result of increased government spending during those periods.
The first bull market started after World War I and lasted until after World War II. According to Dimson, Marsh, and Staunton, the U.S. government kept bond yields artificially low through the inflationary period of World War II and up to 1951. It wasn’t until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term U.S. bond yields then climbed to a high of 15% by 1981. This was the turning point for the century’s second bull market.
The graph below shows real government bond returns for the 20th century. All of the countries listed in the table below showed positive real returns on their equity markets during this period. Ironically, the same could not be said about their bond markets.
The countries that did show negative real returns were those most affected by the world wars. For example, Germany saw two periods in which fixed income was all but wiped out. During the worst of the two periods, 1922-23, inflation reached an unfathomable 209,000,000,000%. According to Triumph of the Optimists, 300 paper mills and 150 printing works with 2,000 presses worked day and night to accommodate the demand for banknotes during this period. The 20th century had more than one episode of hyperinflation, but the one that Germany experienced in the early 1920s was particularly severe.
The graph below contrasts real government bond returns for the first and second half of the 20th century. Notice how the countries that saw their bond markets do very poorly in the first half of the 20th century saw a reversal in their fate in the second half:
This illustration gives you a good feel for the government bond market. According to Dimson, Marsh, and Staunton, the U.S. corporate bond market fared better as well. U.S. corporate bonds added an average of 100 basis points above comparable government bonds during the 20th century. They calculated that roughly half of this difference was related to the default premium. The other half is related to defaults, downgrades, and early calls.
The Bond Market Would Never Be the Same
In the 1970s, the globalization of world markets began again in earnest. Not since the Gilded Age had the world seen such globalization, and this would really start to have an impact on bond markets in the 1980s. Until then, retail investors, mutual funds, and foreign investors were not a big part of the bond market. The article “Fixed Income Management: Past, Present, and Future” by Daniel Fuss provides a useful analysis.
According to Fuss, the bond market experienced more development and innovation in the last two decades of the 20th century than it had in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities, and catastrophe bonds were created. Early investors in these new securities were compensated for taking on the challenge of understanding and pricing them.
The Impact of Innovation
The bond market entered the 21st century coming off its greatest bull market. Long-term bond yields declined from a high of 15% in 1981 to 6% by the end of the century, leading to higher bond prices.
Innovation in the bond market also increased during the last three decades of the 20th century, and this will likely continue. Furthermore, securitization may be unstoppable, and anything with future material cash flows is open to being turned into an ABS. Healthcare receivables, mutual fund fees, and student loans, for example, are just a few of the areas being developed for the ABS marketplace.
Another likely development is that derivatives will become a more significant part of institutional fixed income. The use of instruments such as interest-rate futures, interest-rate swaps, and credit default swaps (CDS) will probably continue to grow.
Based on issuance and liquidity, the U.S. and the Eurobond markets will maintain their dominance of the global bond market. As bond market liquidity improves, bond exchange traded funds (ETFs) will continue to gain market share. ETFs can demystify fixed-income investing for the retail client through simplified trading and increased transparency. For example, BlackRock’s iShares website contains daily data on its bond ETFs.
Finally, continued strong demand for fixed income from the likes of pension funds will only help accelerate these trends over the next few decades.
Bonds in the 21st Century
The bull market in bonds showed continued strength in the early 21st century, but that strength brings the future into question. In the first decade of the 21st century, bonds surprised most observers by outperforming the stock market. What is more, the stock market showed extreme volatility during that decade. The bond market, on the other hand, remained relatively stable, as shown in the table below.
Stocks returned to their dominant position during the second decade of the 21st century. However, bonds continued to produce substantial returns. In particular, the entire U.S. bond market rallied impressively during much of 2019 as the Federal Reserve (Fed) cut interest rates.
Lower interest rates, however, ultimately mean lower returns for bonds in the future. Outside of the United States, negative bond yields have already become normal in Germany and Japan. Bonds with negative yields are guaranteed to lose money in the long run.
The COVID-19 pandemic dramatically impacted humanity and roiled global capital markets. The bond markets were not immune as the economic turmoil dramatically heightened volatility to levels not seen since the Great Recession of 2008.
Treasury bond yields plunged to historic lows as investors sought refuge in the safety of U.S. treasuries. Buoyed by the Fed’s swift response to inject liquidity to support the financial system, the bond market outperformed the stock market for most of 2020. However, equity markets staged a strong comeback to end 2020 with higher nominal returns than bonds.
The Bottom Line
For the most part, investing in fixed income during the past century was not an overly lucrative proposition. As a result, today’s fixed-income investor should demand a higher risk premium.
If this occurs, it will have important implications for asset allocation decisions. Increased demand for fixed income will only help to further innovation, which has turned this asset class from stodgy to fashionable.