Three decades ago, that was what some people said bonds really were. The interest the bond paid would not be enough, they said, to offset the declining value of dollars as inflation added up. The “real” — after-inflation — bond yield would be negative.
That was just as the great bull market in bonds began. Bonds were great investments, and the bond bears turned out to have been dead wrong.
Now we have come full circle. The government is selling bonds that are absolutely, positively guaranteed to not pay enough to offset inflation over the coming years. It is even possible that someone who bought a new Treasury security that will be issued on Monday will end up getting fewer dollars back than he or she invested — interest and principal combined — between now and when the bond matures in 2017.
The securities are inflation-protected Treasury notes. If inflation ticks up significantly over the coming years, investors will get back more dollars than originally invested. But not enough to come close to keeping up with inflation. If there is no inflation, they will get back less than they invested.
When those securities were auctioned last week, buyers agreed to accept a real yield of negative 1.496 percent. It takes a lot of pessimism — about the economy and the future of the United States — to think an investment certain to lose money is an investment worth making.
The great bear market in bonds, both corporates and governments, lasted 35 years, from 1946 to 1981. The bull market lasted about 30 years. A new bear market almost certainly has begun.
If that is true, those seeking a little income now by going out the yield curve will come to rue the decision. They will get the promised interest, but as market interest rates rise, the price of those bonds will decline and decline and decline.
On Oct. 26, 1981, which can be dated as the bottom of the great bond bear market, the yield on 30-year Treasury bonds rose to 15.21 percent. On that date, a Treasury bond issued in 1970 and scheduled to mature in 2000 was quoted at less than 56 percent of face value. It had a coupon of 7.875 percent, but that was not deemed enough to compensate investors for the risk.
At market extremes, it is often worth analyzing what has to be true for a given investment to be a good, or bad, value. Back in 1981, you had to assume that inflation would not only remain in double digits for decades, but that it would also continue to rise, for a newly issued Treasury bond to turn out to be a bad investment. Yet many investors assumed it would be. After all, a lot of people on Wall Street in 1981 could not remember a time when bonds were good investments.
A few weeks before rates peaked, Seth Glickenhaus, an experienced bond trader and head of Glickenhaus Company, an investment advisory firm, spoke the conventional wisdom when he said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”
Michael Gavin, the head of United States asset allocation for Barclays, pointed out this month that over the past 30 years an investor who stayed invested in American, or British, 10-year government bonds would have earned more than 5 percent a year over inflation.
“It does not require advanced market math to understand that returns like these are no longer remotely plausible,” he wrote. “But they say that fish don’t know that they live in water — until they are removed from it — and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond market rally might underestimate some consequences of its termination.”
Even if rates stay where they are for the next five years, and investors collect the interest coupons, he said, “bonds will be transformed from wealth creators into wealth destroyers.”
Or at least they will be unless there is severe deflation. For that is the only situation that will allow today’s new long-term bonds to turn into good investments.
Is that possible? To think it is likely, you pretty much have to assume that economic growth is a thing of the past in both the United States and Europe. It is not an optimistic outlook.
Floyd Norris comments on
finance and the economy at nytimes.com/economix.
Article source: http://www.nytimes.com/2012/12/28/business/reading-pessimism-in-the-bond-market.html?partner=rss&emc=rss
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