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THE RECENT CARNAGE in bonds has been unusually fierce. The Bloomberg Aggregate Bond Index is down more than 7% year-to-date. Unfortunately, this may be the tip of a very large iceberg. I believe we may be standing on the precipice of a multi-decade bear market for bonds.
The reason for my concern can be summed up in one word: inflation. It’s the great enemy of bond investors—and yet, despite an inflation rate that’s at four-decade highs, investors remain far too complacent.
Evidence for this can be seen in the 10-year breakeven rate—the difference in yields between the conventional 10-year Treasury note and 10-year Treasury Inflation-Protected Securities (TIPS)—which now stands at around 2.8%. That implies investors expect inflation to average just under 3% over the next decade. While that number is at multi-decade highs, it could still be too rosy.
Despite the painful bond market decline, the yield to maturity for the broad bond market isn’t much above 2%, which is deeply negative after subtracting the rate of inflation. Since pronouncing the demise of the 60% stock-40% bond portfolio, I’ve pared back my bond holdings—with the exception of inflation-linked Series I savings bonds—from nearly 15% in early January to 5.5% today, using some of the proceeds to buy more international stocks.
The four most dangerous words in investing are, “This time it’s different.” Still, I believe my bearish view on bonds is rooted in fact, not fear. Here are five reasons investors may want to rethink their long-term bond allocation:
1. Real bond yields remain deeply negative.
The inflation rate has been between 7% and 8% over the past three months, based on the Consumer Price Index. The 30-year Treasury now yields 2.67% nominal or about -5% in real terms, assuming an inflation rate of 7.5%. Sure, inflation may eventually fall back to lower levels. But it would need to recede to 2% for real yields to rise above zero. I don’t think that’s in the cards, as I’ll explain in point No. 2.
As a bond investor, there’s isn’t much guesswork when figuring out the returns you’ll likely receive. You need only look at a bond fund’s yield to maturity. Vanguard Total Bond Market Index Fund (symbol: VBTLX) has a yield to maturity of 2.3%, far below the current inflation rate. I don’t know about you, but investing in an asset with a guaranteed negative real return isn’t too compelling.
2. Resurgent inflation is a game-changer.
Over most of the past three decades, we’ve enjoyed sub-3% inflation. Those days may be over. In their recent book, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, economists Charles Goodhart and Manoj Pradhan argue that we will experience resurgent inflation over the coming decades.
If this is true, the Federal Reserve is in a box. It must choose between fighting inflation or preserving economic growth—it can’t do both. If the Fed goes down its current path of raising interest rates and reversing quantitative easing (QE), the economy will slow and most likely head into recession. Both rising interest rates and quantitative tightening mean lower bond prices.
On the other hand, if the Fed pivots to save the economy by lowering interest rates and resuming QE, that’ll add further fuel to the inflation fire. Higher inflation means lower—even negative—real returns for bond investors.
In short, there’s almost no way for bond investors to win. To be sure, it’s conceivable that nominal yields fall—or are driven down by the Fed—toward zero, which would push bond prices higher. But that’s like picking up pennies in front of a steamroller. The risks outweigh the rewards.
3. Bond bear markets can be brutal.
Everyone knows that bear markets in stocks can be punishing. But stock bear markets are mercifully short, averaging just under 10 months. While the bond market is far less volatile year to year, bond investors may instead suffer a death by a thousand cuts. Those cuts are inflicted by—you guessed it—inflation.
A picture is worth a thousand words. Look at the chart titled “Inflation-Adjusted Government Bond Drawdowns: 1926-2017,” courtesy of financial blogger Ben Carlson. Long-term government bonds experienced an after-inflation 60% decline over a period lasting almost 50 years. Five-year bonds didn’t fare much better, suffering a loss of 40% over the same time frame.
4. Bond investors remain complacent about inflation.
Perhaps I’ve convinced you that the outlook for bonds is poor. But could the bad news be priced in already? After all, some of the best investments are made when the news is bleak but what’s priced in is even worse.
Unfortunately, I fear the opposite is true. As I mentioned earlier, the 10-year inflation breakeven implies investors expect roughly 3% inflation over the next decade. That’s far too sanguine.
Let’s look at bonds from the viewpoint of stocks. A bond’s price-earnings (P/E) ratio is just the inverse of its yield to maturity. Vanguard’s total bond market fund has a yield to maturity of 2.3%. That corresponds to a P/E ratio of 43.5. By comparison, at the height of the dot-com bubble in 1999, the cyclically adjusted price-earnings (CAPE) ratio for U.S. stocks was 44.2. Today, the CAPE ratio for stocks stands at 36.5.
When looking at numbers like these, some will argue that the U.S. stock market is not overpriced. Maybe, maybe not. But one thing is clear: Bonds are expensive.
5. Could Treasurys be downgraded—again?
While bonds are typically thought of as the safe portion of a portfolio, it’s worth reviewing the risk of owning bonds. There’s interest rate risk, namely the risk that bond prices will fall should interest rates rise. That risk can be quantified by a bond’s duration—the longer the duration, the larger the interest rate risk.
There’s also inflation risk, which we’ve discussed already. Finally, there’s credit risk, sometimes called default risk. U.S. Treasury bonds are considered to have negligible credit risk, as they’re backed by the full faith and credit of the U.S. government.
In 2011, Standard & Poor downgraded the credit rating for the U.S. one notch to AA+, down from its top rating of AAA. Moody’s and Fitch have maintained their highest credit rating for the U.S.
I’m not predicting another downgrade anytime soon. But the numbers are not reassuring. Total public debt as a percent of gross domestic product peaked at around 136% in 2020 and stands at 123% today. The cost to service that debt could put the Treasury in a real bind, should interest rates rise from today’s historically low levels. No one is talking about this sort of credit risk, but that doesn’t mean it doesn’t exist.
I want to be clear. I’m not suggesting that you make radical changes to your portfolio’s asset allocation. Nor do I suggest you replace your bonds with stocks. Stocks are far risker than bonds, especially in the short term.
But I do think it’s important to give greater thought to the real risks—pun intended—bonds carry in a regime of higher inflation. As I mentioned earlier, I have pared my bond allocation significantly. My largest bond holding is in a TIPS bond fund, as such funds are protected against inflation risk—though they are still subject to interest rate risk. I also plan to continue buying Series I savings bonds, though the major drawback is the $10,000 purchase limit per year.
As readers of my previous articles will know, I also have significant holdings of gold and gold mining companies. Gold has served as a store of value for many millennia and, cryptocurrencies notwithstanding, I expect it to remain so. Gold is particularly attractive when real bond yields are negative, as they are today.
John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.
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