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Bond Buyers Should Be Mindful of History

July 11, 2012 | About:

Burton Malkiel

Market Insight from Burton Malkiel, professor of economics at Princeton University and the author of "A Random Walk down Wall Street" and "The Elements of Investing," published in Financial Times and shared by Tweedy, Browne:

Equities entail less risk than 'haven' investments Investors have been fleeing to "safety". US 10-year Treasury yields fell to less than 1.5 per cent earlier in June, a level not witnessed since 1946 when interest rates were pegged. German 10-year yields fell to an all-time low near 1 per cent. Some very short-term Federal rates were negative, implying that investors were willing to pay governments considered financially stable for the privilege of holding their money. Global equity markets have fallen sharply Investors appear to be far more concerned with the return of, rather than a return on, their money. Since 2008, more than $1tn have been moved from equity funds to bond funds. Similar shifts from equities to bonds have characterised US pension fund allocations.

But does this flight to so-called havens really provide investors with the protection they desire? Or, are bond buyers making a huge mistake that is likely to guarantee them a period of negative real (after inflation) returns? The answer is almost certainly the latter. Bonds today in countries such as Japan, Germany, and the US are more expensive than at any time in history. Bond investors face virtually sure losses and equities are as attractive as they have been in a generation.

We can illustrate the fundamental unattractiveness of bonds with the US market. The buyer of a 10-year US Treasury bond at a 1.5 per cent yield to maturity will receive a nominal return well below the current rate of inflation and below the Federal Reserve's informal target rate of inflation of 2 per cent. Thus, even if inflation does not accelerate, long-term US Treasuries will provide a negative real rate of return. If inflation does accelerate, that real rate of return will be further reduced.

It is important to remember what happened to bond investors the last time that Treasury bond yields were at 1.5 per cent, in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance the debts from the second world war. Therefore, bond prices remained fairly stable. But moderate inflation reduced the real value of both coupon payments and the face value of the bonds, and bondholders lost considerable purchasing power. And that was only the beginning of the pain.

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