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After bonds' extended run, long-term outlook less rosy Add to ...

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at the Richard Ivey School of Business, University of Western Ontario 


Since 1983, bonds have had a terrific run. But after 26 years of rewarding investors, the future for bonds no longer looks promising.

The average annualized return of long-term Government of Canada bonds between 1983 and 2009 was 10.6 per cent, about the same as for the value-weighted stock universe of the University of Western Ontario Canadian Financial Markets Research Center database.

But adjusting for risk, bonds did much better than stocks.

To get a sense of real returns, the average annual inflation rate during this period was 2.5 per cent.

Conversely, the 26 years prior to 1983 were less rewarding for bond investors. Between 1956 and 1982, the returns for Canadian government bonds and stocks were 4.6 per cent and 10.2 per cent, respectively.

Over this period, stocks outperformed bonds both in absolute and risk-adjusted terms. With inflation averaging 5.3 per cent a year, bonds weren't a good investment.

Unlike stocks, it's simple to figure out when bonds are an attractive investment. Bonds are a good investment when interest rates are headed down and they're a terrible investment when rates are headed up. Interest rates experienced a secular decline over the last 26 years, so bonds were a great investment. To forecast returns over the next 26 years, we need to anticipate the long run trend in interest rates.

Underlying all government and corporate interest rates are the real interest rate and expected inflation. When they go up, interest rates increase and vice versa. While in the short run, the real interest rate is affected by the business cycle, the long run trend is affected by factors that change only slowly, namely technology and demographics - it's the outlook for the long run trend of real interest rates that matters. Expectations about future inflation are affected by the business cycle in the short run, and economic efficiency and productivity, as well as by labour, energy and materials shortages and price shocks in the long run.

The late 1970s and early '80s illustrate how the interaction between demographics and technology can push the long-run, real interest-rate trend sharply higher.

Many baby boomers started having kids in the late '70s, fuelling demand for credit to help raise a family. Boomers set little aside for savings and investments. As a result, they restrained the supply of funds available to corporations.

This happened just as the PC revolution started, concurrent with the founding of Apple and Microsoft, and corporations were discovering a growing need for funds to invest in new technologies.

Meanwhile, structural government deficits were growing, leading to increased demand for funds by governments.

As the demand for funds increased and supply shrunk, the long run real interest rate trend increased sharply to about 6 per cent from about 3 per cent.

Additionally, the energy crisis, high consumption by baby boomers and prior underinvestment and inefficiency led to sharply rising inflation and inflationary expectations further pushing rates upwards.

The late '80s and '90s saw declining energy prices, marginal tax rate reductions and productivity improvements along with polices that broke inflationary expectations and led to lower interest rates. Most importantly, as baby boomers matured they started paying off their mortgages just as their kids were leaving home. They started to save and invest, fuelling an explosion in the mutual fund industry. The supply of funds increased, leading to a decline in the real interest rate trend, further suppressing interest rates. These were the golden years for bond investing.

Over the next 26 years, the real interest-rate trend is going to be up. Baby boomers will retire and stop saving, which will reduce the supply of funds. This will happen in the face of increased demand by corporations, as well by increased government needs to borrow to fund structural deficits. To clear the demand-supply imbalance, the real interest rate trend will be pushed up.

We may also be reaching a peak in productivity growth as experienced baby boomers retire and are replaced by less experienced workers who will nevertheless be in high demand. These workers will demand higher wages. This means higher inflation and inflationary expectations.

At the same time, oil and other commodities may be stretched to support growth around the world, contributing to inflationary pressures.

Investors will demand higher interest rates to lend money as compensation for a loss of purchasing power.

While there may be profitable opportunities for bonds in the short run, the long-term outlook isn't promising.

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