How Much Lower Can Bonds Go?

How Much Lower Can Bonds Go?

Government bonds, outside the Eurozone’s periphery, have been among the best performers over the last few years as investors have sought a safe haven. The volatility experienced by most stock markets has further bolstered the allure of government bonds.

A terrific column in the Financial Times, “Bond buyers should be mindful of history,” by Burton Malkiel, Princeton University professor emeritus of economics, says investors have been fleeing to “safety.” Ten-year U.S. Treasury yields fell to less than 1.5 percent in early June, a level not witnessed since 1946. German 10-year yields fell to an all-time low near 1 percent. Some very short-term Federal rates were negative, implying that investors were willing to pay financially stable governments for the privilege of holding their money. According to Malkiel, investors appear to be far more concerned with the “return of” rather than the “return on” their money.

Since 2008, investors have moved more than $1 trillion from equity to bond funds. Similar shifts from equities to bonds have characterized U.S. 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. Malkiel says bonds in countries such as Japan, Germany, and the U.S. are more expensive than any other time in history. He believes bond investors face virtually sure losses, and equities are the most attractive they’ve been in a generation.

Malkiel notes what happened to bond investors the last time Treasury bond yields were at 1.5 percent in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance debt from World War II. Therefore, bond prices remained fairly stable. Moderate inflation, however, reduced the real value of both coupon payments and the face value of the bonds, and bond holders lost considerable purchasing power. And, that was only the beginning of the pain.

Financial history provides numerous examples of market trends that became far overextended and remained so for lengthy periods. Bond investors have been riding one of the most profitable investment trends in history, so many of them will be reluctant to abandon this strategy until they experience profit erosion. When that will happen is difficult to say. Investors who own individual bonds in their portfolio that continue to make sense in this environment may want to stay the course.

Understanding what bonds you own and what to keep or sell is not always easy.

The question remains… How much lower can bonds go?