Getting it Dead Wrong on Bonds

Investors who have been out of fixed income instruments over the last 10 years have missed one of the truly epic risk adjusted rides of the last 100 years.  Over this period US T-bonds have generated an 8% annualized return with a standard deviation of just 13.3.  That’s relative to the S&P 500 which has generated a 7.8% return with a standard deviation of 16.  The aggregate bond index has been even sexier.  The iShares aggregate bond index has generated a 4.5% annualized return with a standard deviation of just 3.8.  This was virtually a risk free return during a period when interest rates have been 0% over much of the holding period.  How many people would have loved having access to a 4.5% return with almost no negative volatility?  My guess is a heckuvalot of people….

What’s even more interesting about this period is that money managers have been almost universally bearish on bonds THE WHOLE TIME.  According to the 2004 Barron’s Big Money poll 73% of investors were bearish on US government bonds and 77% were bearish on corporates.   In 2006 the average respondent had just a 18% allocation to fixed income.  According to the 2013 Big Money poll 91% of respondents were bearish on T-bonds and 82% were bearish on corporates.   So far this year T-bonds are up over 20% soundly beating the pants off of stocks on both a nominal and risk adjusted basis.  In other words, the “big money” has been big time wrong for a long time.

So, what causes this?  How can fixed income represent the overwhelming majority of financial assets, generate some of the best risk adjusted returns over long periods and still remain the ugly stepchild relative to equities?  I can’t be certain, but my guess is that most investors only care to look at the nominal return and have failed to interpret the risk of rising interest rates due to deficient modeling of the macro system.

First, we tend not to care HOW people make their money, but only that they make money.  This obsession with nominal headline returns is why stocks always look sexier.  In general we tend to see academics or researchers backtest 100 year returns on stocks, declare “stocks for the long-run” and we all become convinced that owning a stock heavy portfolio is the high probability way to generate high returns going forward.  And in doing so we lose sight of the bigger picture and how those returns are generated. The fact that we don’t even consider risk adjusted returns in many cases leads us to believe that a high nominal return is a good return even when it often isn’t.  This leads to improper benchmarking based on the S&P 500, endless glorification of high return asset managers and the obsession with stocks.

In addition, I’ve been reading stories about rising interest rates for most of this 10 year period despite the fact that interest rates have stayed low or continued to fall.  There seems to be a permanent belief that since interest rates are low then they must go up.  And since most investors are conditioned to think that rising rates are bad for bonds (they’re not actually – Tbonds generated a 5.6% annual return in the 1970’s) then they conclude that stocks are the only game in town.  This, unfortunately, is not only grounded in the myth that rising rates are bad for bonds, but also in the misunderstandings of the monetary system.  Most investors have a very poor understanding of what drives interest rates, who controls interest rates and how that translates into the risk in owning fixed income instruments.  This lack of understanding results in having no framework or model by which these investors can predict or understand the risks of future returns.

The unfortunate result of all of this is that many investors have not had exposure to this epic ride.  In large part thanks to macro misunderstandings.