Bonds? Why should we bother?

For the past 40 years, holding bonds has been a brilliant idea.

As inflation and interest rates have generally fallen, bonds of pretty much every kind have done well (as their prices rise when interest rates fall).

In the US, according to Deutsche Bank, Treasuries have seen positive real returns over the past four decades.

They have also been fabulous at steadying our portfolios. Holding only equities since 1970 could have given you several potential heart failures but little more in the way of actual return compared with holding a portfolio of 60 per cent equities and 40 per cent bonds. When equities fell in March 2000, and then in 2008-09, bonds did very well, for example.

Can that trend continue? It’s hard to imagine. My pension documents from Aviva, where I have a large part of my default auto-enrolment scheme invested in bonds, alert me to the fact that “as interest rates rise, bond prices fall . . . this would affect the value of your investment”.

The message? It is surely that, if I expect interest rates to rise, I probably shouldn’t hold bonds. Let’s think about that. Back in 2000, about 80 per cent of the global bond universe yielded more than 5 per cent. By the mid-2000s, that was down to more like 60 per cent. Now it’s almost none. Instead, about 80 per cent of bonds yield between 0 and 3 per cent and 20 per cent have negative yields.

Intellectual apathy is not the only reason why the industry keeps buying bonds. The other is regulatory paralysis

At the same time, inflation is back with a vengeance across the world. Central bankers insist it is transient — they reckon that their quantitative easing didn’t push inflation up after the financial crash of 2007 and 2008 and so the current levels of stimulus won’t push it up this time, either.

The rest of us might note that last time around, QE was effectively sterilised by the collapse of bank lending. That isn’t the case this time. Either way, today’s dynamics rather suggest that rates are more likely to rise than fall, and bond prices to fall than rise. And, even if rates don’t rise, unless something dramatic changes in our financial world, they can’t go down much more either.

Flat or falling bond prices might seem unlikely after a 40-year bull market — but they aren’t historically unusual, either. Back to the Deutsche Bank data: this shows us that Treasuries haven’t always been an investor’s dream come true: instead, they have shown a negative real return in six of the 12 decades since 1900, including in four successive decades from the 1940s on.

So here’s the question: if bond holdings are (as it seems) significantly more likely to deliver negative rather than positive real returns from here, why on earth are our fund managers holding them for us? My Aviva fund, for example, is 60 per cent in equities and 20 per cent in bonds.

Part of the answer is habit. Financial market participants are brilliant at extrapolation. Every piece of marketing material announces that past performance is not a guide to the future. Every piece also assumes that it is.

So, if a 60/40 split between equities and bonds and other assets has worked brilliantly in the past, most managers will assume it will continue to do so and most corporate systems will continue to operate on the base assumption that a traditional 60/40 portfolio is both balanced and low risk. Even if it clearly isn’t.

But intellectual apathy is not the only reason why the industry keeps buying bonds. The other is regulatory paralysis. A study out this month from Charles Stanley Fiduciary Management showed that about half of the UK’s professional defined benefit (DB) pension fund trustees want to increase their equity risk.

Lovely, you will say, so why don’t they? Some 40 per cent say they aren’t madly confident in their investment knowledge so they feel a bit nervous about it. But 79 per cent of them gave a second reason: they find the way they are regulated too “stifling”. This, says Charles Stanley Fiduciary Management’s Bob Campion, is “the trustee’s paradox”. They want to take more equity risk but, largely due to regulatory constraints, “they don’t plan to invest in more equities”.

The truth is, says financial historian Russell Napier, that a variety of funds are effectively “regulated to force them to buy government debt”.

This makes sense in an environment in which deeply indebted governments need to sell a lot of bonds to bring in the cash to cover their endless deficits — and don’t fancy paying higher rates than they do at the moment (our debt may be near its highest levels ever but our debt servicing costs remain near their lowest ever).

And there will be more of this to come. So a reasonable expectation from here would be for real bond returns to be a bit like they were in the decades after the war: negative. It would also be reasonable for the answer to the question “why do you buy bonds?” to be “because the regulations said I had to” for the foreseeable future.

Merryn Somerset Webb is editor-in-chief of MoneyWeek. Views are personal. merryn@ft.com. Twitter: @MerrynSW

Letter in response to this article:

For 50 years stocks and bonds correlated closely / From Stephen Essrig, New York, NY, US