Whither bond returns?

September 13, 2013

Mohamed El-Erian has a big-picture look at the bond market today, which leads off with a look back to where we were at the end of April. Back then, a diversified bond portfolio, as measured by the Barclays Aggregate index for the US, showed solid returns, between 3.6% and 6.0%, for every period between 1 year and 20 years. I’ve annotated El-Erian’s chart to show what has happened to those returns in the past 4 months: the numbers on the right are updated to today. As you can see, the 1-year return has fallen from 3.6% to -2.5% — a drop of more than 600 basis points — and all the other figures have fallen as well.

El-Erian explains that the consistent and gratifying numbers posted by fixed-income portfolios were the result of a “virtuous circle”, where four different drivers all fed each other and helped push returns upwards:

  • A secular fall in interest rates;
  • A consistently negative correlation between fixed-income returns and equity returns, over a six-month time horizon;
  • Monster flows into the asset class;
  • Direct support from central banks.

Now, however, those four drivers are coming to an end. Interest rates are at zero; they can’t fall any lower. Over the long term, they have nowhere to go but up. Total assets in fixed-income profiles rose from $4.7 trillion in 1998 to $12.1 trillion at the beginning of 2013 — but now flows have turned negative, and investors are pulling their money out of bonds. And while the Fed is still spending some $85 billion a month buying bonds in the secondary market, that isn’t going to last forever: the taper is coming, sooner or later.

That leaves only the negative correlation between bonds and stocks, which is more of a short-term thing than a long-term thing (after all, both bonds and stocks should post positive returns over the long run), and which is ultimately just a way of greasing the wheels of the virtuous cycle; it can’t do much to boost returns in and of itself.

Which raises the question: we’ve already seen a substantial reduction in total fixed-income returns. If the virtuous cycle is now becoming a vicious cycle, should we expect the numbers to continue to deteriorate for years and even possibly decades to come? Is it possible that in the wake of many years of consecutive positive bond-market returns, we might start seeing a bunch of back-to-back negative returns going forwards?

Simon Lack, for one, would hold that view. El-Erian, who is the world’s largest bond investor, naturally takes the opposite view:

History will regard the ongoing phase of dislocations in the bond market as a transitional period of adjustment triggered by changing expectations about policy, the economy and asset preferences – all of which have been significantly turbocharged by a set of temporary and ultimately reversible technical factors. By contrast, history is unlikely to record a change in the important role that fixed income plays over time in prudent asset allocations and diversified investment portfolios – in generating returns, reducing volatility and lowering the risk of severe capital loss.

The problem is that El-Erian doesn’t really nail his case. He’s good on the short-term factors, and he’s very good on the pockets of the fixed-income universe which are looking particularly attractive right now. If your fixed-income money is invested with Pimco, you can be sure that El-Erian and his thousands of employees are working very hard to maximize the returns that it’s going to generate. But in aggregate, is the bond market still a great place to park long-term funds?

We can be pretty sure that sooner or later, QE is going to end, and then at some point the Fed is going to start raising nominal interest rates. Which means that the bond market as a whole will be, in El-Erian’s terms, sailing into headwinds rather than having the wind behind its back. And although China isn’t going to stop saving any time soon, one does have to wonder whether the fixed-income asset class, which was artificially boosted by risk aversion following the financial crisis, might not see some mean reversion in terms of the total amount of money invested.

For me, the most interesting investing question right now is this one: assuming we’re about to see a long-term secular period of rising interest rates, what can we expect in terms of overall fixed-income returns? There’s no particular reason why bonds shouldn’t continue to see positive and relatively stable returns even if rates are rising. After all, rising rates coincide with greater economic activity, which generally compensates funders for providing capital. And the shape of the yield curve can do a pretty good job of charging borrowers for anticipated future rate hikes.

But the fact is that no one really knows the answer to the question. If you look at El-Erian’s post, it’s good on what’s going to happen in the short term, but it says very little about where returns are going to come from over the long term. Which is probably fair enough. But before I tied up a lot of money with Pimco, or with any other fixed-income investor, I would like to see a thought-through explanation of how and why I shouldn’t be too worried about entering what is sure to be a long-term period of rising interest rates.


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