Many retail buyers avoid the bond market because it does not offer the same degree of upside potential as the stock market. While the bond market is completely different from the stock market, it should not be ignored. It is comparable in measurement to the stock market and has enormous depth.
Triumph Of The Optimists: 101 Years Of Global Funding Returns, a 2002 guide by Elroy Dimson, Paul Marsh and Mike Staunton, can help us assess bonds during the 20th century. We will then consider the effect of innovation. Finally, we’ll take a look at bond market returns throughout the first 20 years of the 21st century.
Key points to remember
- Stock buyers triumphed over bond buyers throughout the 20th century.
- Yields on long-term government bonds fell from a high of 15% in 1981 to 6% at the turn of the century, driving up bond costs.
- During the first decade of the 21st century, bonds stunned most observers by outperforming the stock market.
- Equities have regained their dominance throughout the second decade of the 21st century.
- For most of them, investing in guaranteed income over the last century was not an excessively profitable proposition.
A Wicked Century for Bond Buyers
Stock buyers triumphed over bond buyers throughout the 20th century. The luck premium built on bonds during the 1900s was far too low to compensate buyers for the turmoil to come. This era saw both bear and bull secular markets in the US, which bolstered earnings. Inflation peaked at the end of World Wars I and II due to high government spending during those periods.
The first bull market started after World War I and lasted until after World War II. In response to Dimson, Marsh and Staunton, US authorities kept bond yields artificially low through the inflationary interval of World War II and into 1951. It was not until these restrictions were lifted that the bond market began to reflect the brand new inflationary parameter. For example, from a low of 1.9% in 1951, long-term US bond yields then climbed to a high of 15% in 1981. This was the turning point of the second bull market of the century.
The chart below reveals actual government bond yields for the 20th century. All of the countries listed in the desk below confirmed upbeat real returns in their stock markets throughout this period. In mockery, the same could not be said of their bond markets.
The nations that presented unfavorable real returns were the most affected by the world wars. For example, Germany saw two periods in which the guaranteed earnings were all exhausted. During the worst of the 2 intervals, 1922-23, inflation reached an unfathomable 209,000,000,000%. In response to Triumph of the Optimists, 300 paper mills and 150 printing houses with 2,000 presses worked day and night to meet the demand for banknotes throughout this era. The 20th century saw several episodes of hyperinflation, but the one Germany experienced in the early 1920s was particularly extreme.
The chart below compares real government bond yields for the first and second half of the 20th century. Find out how the countries that noticed their bond markets doing very badly in the first half of the 20th century noticed a reversal in their fortunes in the second half:
This illustration gives you an idea of the federal government bond market. Responding to Dimson, Marsh and Staunton, the US corporate bond market also performed well. US corporate bonds added a median of 100 fundamental factors above comparable government bonds throughout the 20th century. They calculated that about half of this distinction was associated with the default premium. The opposite half is for defaults, downgrades, and early calls.
The bond market would by no means be the same
In the 1970s, the globalization of world markets began again in earnest. It’s not because the golden age had seen the world experience such globalization, and it could really start to affect bond markets in the eighties. Until then, retail buyers, mutual funds and international buyers did not make up a significant portion of the bond market. The article “Fastened Revenue Administration: Previous, Current, and Future” by Daniel Fuss provides a useful assessment.
According to Fuss, the bond market saw more improvement and innovation in the last 20 years of the 20th century than it had in the previous two centuries. For example, new asset prices comparable to inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities and catastrophe bonds have been created. Early buyers of these new titles have been rewarded for taking on the problem of understanding and pricing them.
The impression of innovation
The bond market entered the 21st century by coming out of its best bull market. Long-term bond yields fell from a high of 15% in 1981 to 6% at the turn of the century, causing bond prices to rise.
Innovation in the bond market has also increased over the last three years of the 20th century, and it will no doubt continue. Additionally, securitization could also be unstoppable, and something with material future cash flows is likely to become an ABS. Healthcare claims, mutual fund charges, and college loans, for example, are just a few of the areas developed for the ABS market.
Another likely improvement is that derivatives will become an essential additional part of institutional guaranteed profits. The use of devices comparable to interest rate futures, interest rate swaps and credit default swaps (CDS) will most likely continue to expand.
Based primarily on issuance and liquidity, US and Eurobond markets will retain their dominance in the global bond market. As bond market liquidity improves, bond exchange-traded funds (ETFs) will continue to gain market share. ETFs can demystify fixed income investing for the retail consumer through simplified buying and selling and increased transparency. For example, BlackRock’s iShares website includes daily news about its bond ETFs.
Finally, the continued strong demand for fixed income from pension funds will only serve to accelerate these characteristics in the coming years.
Bonds in the 21st century
The bond bull market confirmed continued energy at the start of the 21st century, but this energy calls the long term into question. During the first decade of the 21st century, bonds stunned most observers by outperforming the stock market. Additionally, the stock market has confirmed excessive volatility throughout this decade. The bond market, again, remained relatively stable, as shown in the chart below.
Equities have regained their dominance throughout the second decade of the 21st century. Nevertheless, bonds continued to provide substantial returns. In particular, the broader US bond market rallied impressively throughout 2019 as the Federal Reserve (Fed) cut interest rates.
Lower interest rates, however, ultimately imply lower bond yields sooner or later. Outside the US, unfavorable bond yields have already become regular in Germany and Japan. Bonds with unfavorable yields are guaranteed to lose money in the long run.
The COVID-19 pandemic has had a dramatic impact on humanity and disrupted international financial markets. Bond markets were not immune as the financial turmoil dramatically increased volatility to levels not seen since the Nice recession of 2008.
Treasury yields plunged to historic lows as buyers sought refuge in the safety of US Treasuries. Supported by the Fed’s quick response to inject liquidity to help the monetary system, the bond market outperformed the stock market for most of 2020. Nonetheless, equity markets staged a strong comeback to end 2020 with higher nominal yields than bonds.
The back line
For most of them, investing in guaranteed income over the last century was not an excessively profitable proposition. Therefore, at present, the bond investor should demand a better risk premium.
If this happens, it will have necessary implications on asset allocation choices. The high demand for secure income will only contribute to the further innovation, which has transformed this asset class from heavyweight to modern.