[The data on corporate bond returns in this post were updated in January of 2022.]

Many folks visit Mindfully Investing to check out the historical returns data for various asset classes.  So, today’s post is another installment in my ongoing expansion of the historical returns data sets provided here at Mindfully Investing.  In this case, I want to take a look at the history of corporate bond returns.

I haven’t written much about corporate bonds in the past, mainly because corporate bonds tend to have relatively low yet predictable returns, but with higher risks than relatively safe government bonds.  So, if you’re adding risk to your portfolio to beat the returns of government bonds, stocks are likely a better choice than corporate bonds. Alternatively, consider diversifying into mortgage notes or note funds backed by residential real estate. However, this statement is a considerable oversimplification, which is why I wanted to take a closer look at the historical returns (and risks) for corporate bonds.

What Is A Corporate Bond?

The major asset classes addressed at Mindfully Investing are stocks, bonds, and cash.  A bond represents a loan from the investor to the bond issuer (for example, the U.S. government).  The bond issuer pays interest to the investor at a specified amount and frequency over the life of the loan and then pays back the loan principal (the “face value” of the bond) at a specified future date (the “maturity date”).

A corporate bond is when a private company or corporation requests such loans on the open market.  Corporate bonds are typically issued in blocks of $1,000 in face value.  Like all bonds, the corporate variety can be traded in the bond markets after the initial purchase, which impacts the price of the bond over time, but not its original face value.  As with stocks, you can also buy baskets of corporate bonds through mutual funds or exchange-traded funds (ETFs).

As I already alluded, corporate bonds generally have higher volatility, and therefore higher implied risks, than U.S. government bonds.   So, corporate bond interest rates (yields) are almost always higher than government bond yields, even for companies with excellent credit ratings.  The companies issuing corporate bonds are evaluated for risks like non-payment of interest or loan default by one or more of three U.S. rating agencies: Standard & Poor’s Global Ratings, Moody’s Investor Services, and Fitch Ratings.  Confusingly, each agency has its own rating system, but generally, the highest quality bonds are given some form of “triple-A” rating (like AAA).

Here’s a generic list of bond ratings that gives you an idea of the hierarchy of corporate bond quality:

• AAA – highest quality
• AA
• A
• BBB
• BB
• CCC
• CC
• C
• D – lowest quality

So, a bond with a BB rating has a higher risk of default than a bond with a BBB rating. If you want to see all the rating categories from each rating agency, Fidelity presents a complete list here.  Bonds rated “BB” and lower are called “high-yield” bonds because they typically pay higher interest than similar high-quality bonds.  But they’re also called “junk” bonds because of the greater risks implied by the lowest ratings.  Conversely, bonds above the BB level are called “investment-grade” bonds due to the lower implied risks.

Historical Returns of Corporate Bonds

The longest continuous record of annual returns I could find for any type of corporate bond goes back to 1928, as presented by Aswath Damodaran at New York University’s Stern School of Business.  This includes data for AAA-rated bonds and BBB-rated bonds, which represent both ends of the spectrum of investment-grade bonds.

Based on these data, the nominal (not inflation-adjusted) average annualized return (also known as Compound Annual Growth Rate; CAGR) for investment-grade bonds from 1928 through 2021 was:

• AAA Rated Corporate Bonds – 5.8%
• BBB Rated Corporate Bonds – 6.9%

Also, I found Portfolio Visualizer data going back to 1979 for lower quality junk bonds.  Although the shorter period clouds direct comparisons with the investment-grade bond returns above, the nominal average annualized return for junk bonds since 1979 was:

• Junk Bonds – 7.9%

However, these are all long-term averages, which means that over shorter periods corporate bond returns have diverged substantially from these averages.  This table shows some additional descriptive statistics for the nominal annual returns from AAA and BBB rated corporate bonds back to 1928 and junk bonds back to 1979.

As we would expect, lower-quality investment-grade bonds (BBB) and junk bonds have experienced more variable annual returns than AAA bonds.  On average in this period, AAA bond returns were outpaced by BBB bond returns by about 1.1%.  Thus, investors in lower-quality bonds were compensated for the additional risks implied by lower ratings.

You may be interested in determining annualized corporate bond returns for specific historical periods.  Similar to my historical return calculators for stocks, bonds, and cash, these three calculators provide annualized corporate bond returns (both nominal and inflation-adjusted) between any two dates based on data from Damodaran (back to 1928 for AAA and BBB bonds) and Portfolio Visualizer (back to 1979 for junk bonds).

Historical Risks for Corporate Bonds

Volatility, as measured by the standard deviation of the routine ups and downs of returns over time, is the most common (but somewhat flawed) measure of investment risk.  Because higher returns are usually associated with higher risks of losing money, it’s prudent to evaluate the long-term balance of both returns and risks for every investment.

Unfortunately, we don’t have continuous volatility data going back to 1928 as we do for returns data.  In fact, I had great difficulty finding suitable corporate bond volatility data going back more than 10 years.  However, I eventually found a 2019 research paper Bekaert and De Santis that examined the volatility of various corporate bonds from 1998 to 2018 (a 21-year history).  They found the following standard deviations for AAA and BBB bond returns:

• AAA bonds – 6.7%
• BBB bonds – 6.2%

It’s puzzling that BBB bonds had lower volatility than AAA bonds in this period.  But this may simply show that, in the uncertain world of investing, short-term results don’t necessarily follow long-term historical trends.

And to round out the field, from Portfolio Visualizer data, we can say that the volatility of junk bonds from 1979 to 2019 was:

• Junk bonds – 7.3%

In this case, junk bond volatility is higher than investment-grade volatility above, as we would expect.

Corporate Bond Returns/Risks as Compared to Other Major Assets

So, now we have decent estimates of both returns and risks for corporate bonds across the full range of quality ratings.  But how do those data compare to the balance of returns and risks available from other asset classes?  Here’s a graph plotting risk versus returns for many of the asset classes and subclasses that I’ve written about here at Mindfully Investing.

The graph shows results from 1998 to 2018, which is the same period used in Bekaert and De Santis research.  The squares represent the actual returns (CAGR) and risks (standard deviation) in this period, and the round dots represent the “theoretical”² or expected relationship between risk and returns for these asset classes.  Actual returns and risk data are from Portfolio Visualizer, except for AAA and BBB corporate bonds, which are from the Bekaert and De Santis study.

The best-fit line for the theoretical relationship between these asset classes differs substantially from the best-fit line for the actual data for the 21 years from 1998 to 2018, particularly at the high-risk (right side) of the graph.  Put another way, the actual returns in this period for emerging market stocks, developed market stocks, and U.S. large-cap stocks were much lower than generic expectations for these assets.  Conversely, the returns for BBB corporate bonds were notably higher than generic expectations.

All this suggests that the data from 1998 to 2018 could be a poor illustration of the typical long-term relationship between these assets.  Portfolio Visualizer contains corporate bond data (with no differentiation of AAA, BBB, or other types of investment-grade bonds) extending back to 2003.  So, I built a similar graph covering the almost 18-year period from the start of 2003 through to May 2020.

Although this period starts only five years after the previous graph, the relationship based on actual data is much more closely aligned with generic expectations for these assets.  Further, the unusual performance of investment-grade corporate bonds (particularly BBB) over the two decades starting in 1998 disappears if we start the calculation just a few years later.

The decadal variations in risks/returns shouldn’t be surprising because we know that the returns/risks of any given asset vary substantially over time.    A good example of corporate bond risk/return variations is provided by these two graphs from an Alliance Bernstein study back in 2013 of junk bond risks/returns.

So, armed with the detailed data and associated caveats we can make some broad generalizations about the risks and returns of corporate bonds as compared to other asset classes.  In general, we can rank the asset classes in terms of long-term risks and returns in increasing order:

• • Cash
  • Government bonds
  • Investment-grade corporate bonds
  • Junk (or high-yield) corporate bonds
  • U.S. stocks (as represented by large caps)
  • Developed market stocks³
  • Emerging market stocks

Focusing more on today’s topic, we can also say that, over the long-term, corporate bonds generally produce about a half to three-quarters of the returns of U.S. stocks, but at times, they can outperform stocks, as the graphs above demonstrate.  More interestingly, corporate bonds, even junk bonds, tend to have about half the volatility of stocks.  Put more simply, corporate bonds tend to have a better return to risk ratio than stocks.

However, the last graph shows that corporate bond volatility can abruptly increase when the markets are in turmoil.  From 2007 to 2009, junk bond volatility spiked by about a factor of three, from 5% to nearly 15%!  Volatility of only 5% is certainly typical of sedate bonds, but 15% volatility is much closer to what we would normally expect for stocks.

Conclusions

The history of corporate bond returns and risks suggests two potential perspectives.  If you are risk-averse and are starting with a portfolio that contains mostly government bonds, adding some corporate bonds (even junk bonds) may be a prudent way to moderately boost your long-term returns without adding huge risks.  But if you are more comfortable with risk (that is, you’re a mindful investor) and already have plenty of stocks in your portfolio, there’s no compelling argument for adding corporate bonds, beyond the diffuse benefits of generic diversification.  That’s because corporate bonds (particularly investment-grade bonds) have rarely exceeded stock returns, while sometimes generating stock-like volatilities (particularly junk bonds).

Given this blog is about mindful investing, I see things from the second perspective.  But I have to say that this examination of corporate bonds has piqued my interest in BBB and junk bonds as a potentially better form of portfolio ballast than government bonds.  Over the long term, corporate bonds have shown a higher return potential than government bonds, with volatilities that are usually well below that of stocks.  But because of the very low expected future returns for all kinds of bonds, I wouldn’t add corporate bonds (or bonds of any kind) to my portfolio until interest rates and bond yields are substantially higher than they are today, for reasons I’ve already summarized in this recent post.

1 – The arithmetic average of annual returns differs from annualized returns (CAGR) as discussed more here.

2 – By “theoretical”, I mean that a quick review of any basic investing references shows that professionals assume a certain hierarchy of risks and returns among these asset classes based on historical data and experience.  Nonetheless, it’s widely understood that the actual hierarchy of risks or returns in any given period can vary substantially from this theoretical assumption.  

3 – Note that in the periods examined in this post, developed-market stocks did not strictly follow this hierarchy because they had higher risks than U.S. stocks but lower returns.  Further, it’s been so long since developed-market stock returns beat U.S. stock returns, that some experienced investors would likely reverse the hierarchy of these two assets.

I’ve been resisting the temptation to post about the recent market turmoils.  After all, mindful investors ignore market gyrations whether they’re caused by scary-sounding global pandemics or anything else.  Mindful investing is the same regardless of the market’s volatility:

• Buy a moderately diversified set of low-cost stock index funds and hold them for the long term (at least 10 years).

You’ll note that this summary doesn’t mention bonds.  Mindful investors don’t have much use for bonds, at least at the super-low yields they’ve offered for the last half-decade.

So, I’m puzzled by the many recent news articles and posts citing the ongoing correction as a “perfect” example of why investors need some bonds in their portfolios.  This graph of Portfolio Visualizer returns data for the last two months explains why some people are crowing about bonds right now.  Stocks are represented by the S&P 500 and bonds by the U.S. 10-year Treasury bond.

I’ve also included here a “combined” portfolio consisting of 60% stocks and 40% bonds because it’s the most commonly mentioned simple portfolio for individual investors.  Stocks have had a dismal start to 2020, and bonds have so far proved to be a fantastic safe haven.  Does the Mindfully Investing logic supporting stock-heavy portfolios have a big hole in it where the bonds should be?  When the stock market is convulsing, are we mindful investors making a terrible mistake by holding zero bonds?

The short answer to both questions is no.  Mindful investors should take comfort that all of the problems inherent with investing in super low-yield bonds remain.  If anything, most of the problems with bonds have gotten worse over the last month of market mayhem.  In this post, I examine two major claims for why bonds were “essential” during the recent market correction, and why these claims are still unconvincing to an investor with a mindful perspective.

1. Bonds Rise When Stocks Fall

Probably the most common reason people buy bonds is that they expect them to mitigate stock losses in a combined portfolio.  The combined stock/bond portfolio is rooted in the fundamentals of diversification, where investors seek assets that zig when their other assets zag.  The returns for 2020 so far are indeed a good example of bonds fulfilling this function in a combined portfolio.  And historical data provide further support for this idea.  This graph shows how bonds performed in years when stocks had negative returns based on Aswath Damodaran stock (S&P 500) and 10-year U.S. bond data.

Over the past 92 years, annual stock returns were negative in 25 cases or about 27% of the time.  Putting bonds aside for a second, that’s a good reminder that negative annual stock returns are a relatively uncommon occurrence, and that’s why mindful investors like to invest in stocks.  But getting back to bonds, in only three of these 25 down years for stocks were bond returns also negative.  That’s a pretty impressive track record for bonds.

However, comparing 100% bonds to 100% stocks is not particularly realistic.  Almost no one recommends 100% bonds for any investor¹ because most of the time, long-term bond returns have been dismal relative to stocks.  So, what happens if we instead examine the historical performance of the standard 60/40 portfolio in years when stocks posted negative annual returns?  Here’s that graph.

The solid blue line in this graph shows a theoretical one-to-one relationship between the returns of two portfolios.  If a portfolio’s returns fall below that solid blue line, that means it performed worse than the 100% stock portfolio.  Although the stocks in the 60/40 portfolio dragged down its overall performance to some extent in negative stock years, the 60/40 portfolio beat the 100% stock portfolio (all the dots are above the solid blue line) in all of these historical cases.  The dotted blue line on the graph shows the best-fit for the historical data.  Interestingly, this best-fit line indicates that the 60/40 portfolio mitigates stock losses by about half.  For example, the dotted line intersects the point where stocks decline by 20% (horizontal axis) and the 60/40 portfolio declines by about 10% (vertical axis).  That seems like pretty good mitigation of stock losses.  But to be clear, when stock returns are negative, the 60/40 portfolio usually won’t produce positive annual returns.

Assets that mostly move together are “positively correlated”, while those that tend to move in opposite directions are “negatively correlated”.²  We’ve seen some pretty strong evidence that annual bond returns are negatively correlated with annual stock returns.  But looking at annual data gives a somewhat false impression of the dynamic nature of stock/bond correlations.  The claimed negative correlation between stocks and bonds has varied substantially over time, and it’s only in the last 20 years that the correlation has been negative.  And as shown in this Portfolio Visualizer graph of two long-lived Vanguard mutual funds (VFINX for stocks and VBFMX for bonds), even in the last 20 years, stocks and bonds were only mildly and sporadically correlated in the hoped-for negative direction.

Given this history, no one can guarantee that bond returns will be negatively correlated with stock returns under all future market conditions.  The current relationship between these assets could reverse and start to mimic the 1990s.  And 2018 recently reminded all of us that bonds and stocks can both have negative returns in the same year.

Although bonds in a combined portfolio have a good historical track record of loss mitigation, that mitigation is partial (about half in the case of the 60/40 portfolio).   And the variations in stock/bond correlations suggest it would be unwise to expect that degree of mitigation for every future market condition.  Overall, I give the bond proponents half-credit for this claim.

2. Rebalancing With Bonds Can Beat Stocks

One question with diversified or combined portfolios is whether to “rebalance” them.  Given that different assets produce different returns over time, the proportions of assets in a combined portfolio can drift significantly over time.  Rebalancing involves periodic resetting of a combined portfolio back to its original proportions to correct for this drift.  This is often purported to create a “rebalancing bonus” of increased long-term returns.

My past examinations of rebalancing show that rebalancing stock/bond portfolios often fails to produce a rebalancing bonus as compared to non-rebalanced portfolios, particularly when investing over many years.  And researchers have found that the rebalancing bonus is mostly a product of the combined luck of when you choose to rebalance and what the markets are doing at the time.

Nonetheless, I recently saw a graph from 1986 to 2020 showing that a portfolio of 100% stocks underperformed a combined stock/bond portfolio that was rebalanced twice a year.  I tried to recreate that graph using Portfolio Visualizer and got somewhat different results.  Here’s my graph showing the growth of a $10,000 initial investment.  The blue line is 100% stocks (S&P 500), the orange line is a 60/40 portfolio rebalanced quarterly³, and the red line is 100% bonds (U.S. 10-year bond).

Even though stocks still beat the 60/40 portfolio by my calculations, the rebalancing of the 60/40 portfolio produced an annualized return of 9.5%, which was pretty close to the annualized return of 10.4% for the all-stock portfolio, and much better than the 6.8% return from the all-bond portfolio.  However, basing conclusions on this one time-period is pretty misleading because it coincides almost exactly with the entirely unprecedented 37-year bond bull market.

For a wider perspective, we can examine how often a rebalanced 60/40 portfolio outperformed a 100% stock portfolio by looking at annualized 5-year rolling returns using the Damodaran data going back to 1928.  Because these are annual return data, my calculations assume annual rebalancing of the 60/40 portfolio.  This graph shows the difference between 5-year annualized returns for the two portfolios over time.

When the blue line is in positive territory, it means that the 100% stock portfolio had higher returns than the 60/40 rebalanced portfolio.  The orange hatching shows the reverse situation when the rebalanced 60/40 portfolio outperformed 100% stocks.  It turns out that most of the time the 100% stock portfolio has outperformed a rebalanced 60/40 portfolio.  Most of the exceptions include at least one recession, although stocks weathered many other recessionary periods better than the combined portfolio.  So, it’s reasonable to say that a rebalanced stock/bond portfolio sometimes outperforms an all-stock portfolio, but it’s more the exception than the rule.  Stocks had superior long-term returns performance relative to the 60/40 portfolio, even during the nearly 40-year bond bull market.  So, I give bond proponents zero credit for the claim that a rebalanced stock/bond portfolio beats an all-stock portfolio.

Other Claims About Bonds

Most of the other claims I’ve seen recently about bonds are the same recycled stuff that’s been around for years, which I’ve covered in past articles on bonds.

For example, the idea that bonds offer decent returns with less volatility is refuted by the fact that long-term bond returns have been historically half that of stocks, and reduced volatility does not equal reduced risk.  Further, the best predictor of total returns over a bond’s duration is the bond’s current yield, and yields are incredibly low right now.  The 10-year U.S. bond currently yields less than 0.8% (an all-time low), while my online savings account is still paying 1.5% in annual interest.  So, saying it’s a good idea to lock in a 0.8% total return for the next 10 years is absurd, regardless of how low bond volatility may be.  You can’t fund your retirement with low volatility.

Another recycled claim is that bonds provide regular income for retirees.  But of course, most retirees will find their nest eggs entirely insufficient to fund retirement on less than 1% income.  Again, locking in a miserable return for 10-years is way worse than putting that money in a lowly savings account and looking for better options when interest rates and bond yields start to normalize.

Conclusions

The supposed benefits of bonds all seem to circle back to emotional, not rational reasons.  Mitigating stock losses sounds great, but if over the long term, stock returns handily trounce bonds, what’s the point?  It seems the point is to feel better when the stock market crashes.

However, I submit that few advisers or individual investors know for sure exactly how they will react to the next stock market crash.  We’ve seen that the standard 60/40 portfolio has historically halved the magnitude of temporary negative stock returns.  So, if stocks drop by 40%, while the beloved 60/40 portfolio drops by 20%, is everyone so sure they won’t panic sell at -20% anyway?  Every green soldier wonders whether they might be paralyzed by fear in combat, and none of them knows for sure until the battle starts.  Some portion of the investing population will undoubtedly breakdown and sell some or all of their 60/40 portfolio at -20%, or even -10%.

There are tons of folks on Reddit and Twitter that already sound close to panic, even though the stock correction has been relatively mild so far.  Having a stock/bond portfolio in no way inoculates you against emotional decisions in an uncertain future.  Many people will benefit from practicing mindfulness or similar calming techniques to avoid emotional decisions, regardless of what portfolio they hold.

And if that’s true, all the benefits of bond investing evaporate, because they all assume that reducing volatility is the only way to handle our emotions.   If you have a hammer, everything looks like a nail.  For finance folks, it seems that every problem needs a financial solution, even when a mental or emotional solution might work much better.

1 – The main exception is that some advisers recommend 100% bonds for investors that are deep into retirement.  But I generally disagree with that notion for many of the same reasons that I’m writing about today.

2 – And if two assets move randomly to each other, they are “uncorrelated”.

3 – Quarterly rebalancing gave me the highest returns for the 60/40 combined portfolio.

Among the primary asset classes, bonds are supposed to be the boring mini-van and stocks the thrilling sports car.  But over the last few weeks, everyone seems to be hysterical about bonds.  Check out the crazy twists and turns in the recent headlines about bonds:

• The 30-Year Treasury Bond Yield Plunges to an All-Time Low
• The Bond Market Is in a Bubble
• Bonds Are Frickin’ Expensive
• Ex-Fed Boss Says “There’s No Barrier” to Negative Bond Yields
• Bond Markets Are Sending One Big Global Recession Warning
• A Bond Up 65% in 2019

Should mindful investors head for Bond Street or take a detour instead?

The Mindful View of Bonds

Before we try to navigate all the excitement, let’s review the mindful take on bonds and their role in an investment portfolio.

• Bonds have almost always generated substantially worse long-term returns than stocks.
• A bond or bond fund’s current yield is an excellent predictor of future annualized returns for the duration of the bonds involved.
• Bond yields (and expected long-term returns) are incredibly low by any historical measure.  For example, the 10-year Treasury bond yields only 1.5% as I write this post.  In contrast, right now you can easily set up a safe cash savings account that offers 2% interest.
• Traditionally, bonds provide “ballast” in a diversified portfolio, where stocks generate most of the long-term returns and bonds help reduce portfolio volatility.
• Bond ballast is not particularly beneficial for most mindful investors because we care less about routine volatility and more about on long-term returns.
• One exception is that “older” mindful investors can use bond ballast to reduce “sequence of return risks” a few years before and after their retirement date.
• But even in this one case, because bond yields are so low right now, cash can work just as well or even better than bonds as ballast.

With all the recent bond market turmoil, have any of these conclusions changed?

Navigating the Headlines

The finance news can be very misleading.  So, maybe there’s less turmoil than these feverish headlines would suggest.  Let’s examine some of the main concerns about bonds using the four cornerstones of mindful investing: rationality, empiricism, patience, and humility.

Historically Low Yields – People have been concerned about unprecedented low bond yields for quite a few years now.  I first wrote about low bond yields in a 2016 article that included two relevant charts.  The first is from NewFound Research and goes back to 1875.

And the second is from Merrill Lynch, which uses interest rates as a proxy for bond yields and goes back 5000 years!

So, we’ve known about crazy low bond yields for quite some time now.  But the recent dip in bond yields from their late 2018 interim highs seems to have rekindled the frantic headlines.  Here’s a 5-year chart of the 10-year Treasury bond yield.

The 10-year yield has fallen more than 1.5% in the last few months, but it’s still slightly above the July 2016 all-time closing low of 1.38%.  However, the 30-year bond just hit a new all-time low under 2%.

But because long-duration bonds are particularly sensitive to interest rate changes, most investors seeking bond ballast are more interested in funds with around a 7 to 10-year duration.  Accordingly, the most important point is that the 10-year bond yield is still above its all-time lows.

So, we have some new trends developing, but there hasn’t been a huge shift in the bond situation in the last three years.  Keeping in mind that current bond yields usually predict future total returns, the mindful conclusion that bonds will continue to generate inferior returns for the foreseeable future is still valid.  If bond yields continue to fall for another year or two, some short-term gains will be generated as bond prices rise even more in response.  But for long-term investors, those early gains will likely be counteracted by subsequent losses when bond yields eventually rise again and prices fall.

Bond Bubble or Just Frickin’ Expensive – Because bond yields and prices are inversely related, it’s no surprise that bond prices are extremely high.  Longview Economics Chief Market Strategist Chris Watling looked at four common criteria for defining a market bubble: high availability of cheap money, increased borrowing to invest, historically extreme valuations, and a convincing narrative to justify unusually high prices.  He found that pretty much every one of these criteria confirms we’re in a bond bubble.  Defining the “convincing narrative” seems particularly speculative because it’s always difficult to discern the central themes of history in real-time.  In this case, Watling offers the narrative that most developed economies have become addicted to the low interest rates set by central banks.  So, any economic weakness will spur a feedback loop of more interest rate cuts and money printing, which will drive bond prices even higher.

Cliff Asness at AQR looked at two related bond valuation measures: real (inflation-adjusted) bond yield and the slope of the yield curve.  He found that both measures are at 5th percentile lows (indicating high bond prices) for the last 60 years as shown in these two charts.

Only 5% of the time in the last 60 years have these measures been any lower than they are today.

Concerns about bond bubbles today are the latest reverberations of the same concerns that have been around since at least 2016.  Then as now, bonds will possibly continue to generate short-term price gains, which will then likely be followed by counteracting losses and dismal long-term annual returns (for example, in the 1.5% range for 10-year bonds).  This “news” is getting pretty stale.

Here Comes Negative U.S. Bond Yields and A Global Recession – According to these types of articles, “The bond market is screaming [economic] recession”.  One source of the screams is the recently inverted bond yield curve in the U.S.  That’s when short-term bonds have higher yields than intermediate bonds, which is the opposite of the normal relationship.  I won’t get into the details about yield curves here, but if you want to know more about them and why “inverted” ones often presage recessions, here’s a good place to start.

Another source of concern is that more countries in the world are starting to issue bonds with negative yields or are going deeper into negative yield territory.  (I wrote a bit about negative yields and what that means in this article and this article by Vineer Bhansali has a good explanation of how they work.)  Many experts see no reason why U.S. bond yields couldn’t eventually go negative too.

So, we see some reasonable signals that an economic recession might be on the way.  Keeping in mind that no one can consistently predict the future, what does that mean for the mindful investor?  An economic recession usually results in a stock market correction or even a crash.  Central banks usually attempt to minimize the severity of a recession’s impacts by lowering interest rates either before or after the recession starts.

Essentially, the media is highlighting that bonds can be a canary in the coal mine for stocks.  But mindful investors know that recessions and market corrections happen periodically and the stock market has always eventually rebounded to new highs.  The key to winning the game of long-term investing is to keep playing through thick and thin and avoid “panic selling”, which simply locks in your losses.  So, there’s nothing new or actionable here for the mindful stock investor.

Better Bond Returns – While most recent headlines seem to be warnings, some folks are focused on the potential opportunities implied by recent bond price movements.  How have recent bond returns compared to stocks, the favored asset of mindful investors?  Here’s a table comparing year-to-date and 3-year returns of representative intermediate and long-term bond Exchange Traded Funds (ETFs) to the S&P 500 stock index (represented by VOO).  I used a three-year horizon for the second comparison because that’s about how long people have been fretting over low bond yields.

So far in 2019 long-term bonds have substantially outperformed stocks.  However, if you had held that same bond fund since mid-2016, you would have received pretty typical bond returns while substantially lagging stock returns.¹  Holding intermediate bonds instead would have generated even worse results.  Further, long-term bonds are more susceptible than intermediate bonds to price declines when interest rates rise.  As a result, chasing this opportunity for higher bond returns adds meaningful additional risks.  Anyone emphasizing bond “opportunities” is assuming that you’re playing a very short-term and relatively risky game that is the antithesis of government bonds as a “safe haven”.

Such short-term speculation is known as “market timing”.  Unfortunately, substantial evidence shows that even the very best investors fail to consistently and successfully time the market.  Headlines that tout short-term bond returns are just click-bait for get-rich-quick schemers, who are the opposite of mindful investors.

A particularly egregious example of market-timing headlines was the Seeking Alpha article: A Bond Up 65% in 2019.  The pseudonymous author “Ploutos” uses the Austrian 100-year bond mostly as an example to explain the concepts of duration and convexity.  A more relevant and boring headline like “An Example of How Duration and Convexity Are Important to Portfolio Construction” wouldn’t have attracted a lot of clicks.

Regardless, Ploutos notes that in September of 2017 the Austrian government issued a century bond with a starting yield of 2.1%.  Assuming that the yield is predictive of the total future return even for very long-term bonds², investing in the Austrian century bond when it was issued would have essentially locked in a dismal return for a hundred years.³  Of course, in all likelihood, most investors in these bonds are playing some sort of short-term market timing game and aren’t planning to lock in a poor return for 100 years.

As a long-term investment strategy, century bonds are probably one of the least mindful investment options on the planet.  The only thing that the year-to-date 65% return on Austrian century bonds tells us is that a few people probably got extremely lucky in the first half of 2019.  And if they don’t sell soon, they’re in for a bumpy road ahead when there’s even a hint of a rumor that interest rates could start to rise.

Conclusions

The investing world is in a tizzy about bonds, but for reasons that are mostly irrelevant to the long-term investor.  As is so often the case, a mindful review of the situation shows us that the mindful investor should simply ignore the hysteria and stick his or her long-term investing plan.

1 In case you think I’m cherry-picking my performance period here, I also looked at periods going back 4 to 20 years.  And the only time in recent history that long-term bonds generated a superior annualized return to stocks was if you had started investing exactly in the year 2000.

2 I’d guess that many bond experts would agree with this assumption, but some might not.

3 And investing in the same Austrian century bond now offers an even more dismal yield of 0.8% (locking in a similar long-term return consistent with my assumption) because the yield has plummeted as the price has sky-rocketed.