The bond market outlook was once positive—but not now. In fact, it puts investors at risk of capital losses if inflation or interest rates rise

The bond market outlook had a lot of investor appeal in the turbulent years of the 1930s and 1940s. Back then, business was weak and volatile, due to the depression and the stress of the Second World War. Inflation was subdued, due to price controls, high taxes, and political and economic uncertainty. Interest rates on bonds stayed in the 2% to 4% range.

Beginning in the mid-1950s, however, everything changed. Business boomed, the stock market began rising in earnest, and interest rates set off on a secular rising trend that lasted a quarter century.

Bond yields (based on 10-year U.S. government bonds, for instance) rose from the 3% to 4% range in the mid-1950s, to a peak just below 16% in September 1981. Inflation continually soared in those years as well, peaking at around 15% in 1981.

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A secular trend lasts over a series of business cycles (which typically average four years each), unlike most economic trends.

When secular trends get underway, they seem to acquire a life of their own. Periodically it seems they can’t go any further, and then they go further still. After a while, observers quit looking for signs that a secular trend is coming to an end. That’s when the end is near. Of course, “near” is a matter of opinion when a trend has been going strong for over three decades.

Bond market outlook not so great today

When bonds yielded 10%, perhaps it made some sense for investors to buy bond mutual funds and pay a yearly MER of, say, 2%. Now that bond yields are substantially lower, it makes a lot less sense.

The bond market is also highly efficient, and few managers can add enough value to offset their management fees. Additionally, investing in these funds exposes you to the risk that a manager will gamble in the bond market and lose money.

Inflation is another threat to bond funds. If the funds hold their bonds to maturity, they will get back the bonds’ full value—but inflation would cut the purchasing power of the bond’s face value.

As a general rule, the safest bonds are issued by or guaranteed by the federal government. Next come provincial issues or bonds with provincial guarantees.

Corporate bonds can be far riskier than government bonds, and that risk varies widely. Some corporates are almost as safe as government bonds and offer only slightly higher yields. Some corporates are far riskier and offer far higher yields.

Asset allocation and the bond market outlook

If the managers feel that the bond market is depressed and poised for an upswing, they may overweight the portfolio in fixed-income investments for a few months to take advantage of the change. Adding computer modelling makes this investment approach sound even more scientific, but it is just as likely to detract from a portfolio’s long-term returns as it is to add to it.

Asset allocation is overrated as an investment tool. Asset-allocation strategies rose to prominence because the investment industry seized on some academic research on the subject and turned it into a sales pitch for investment products that carry much higher fees than regular stocks and bonds.

Bond market outlook: Bonds can offer false security

Bond enthusiasts acknowledge that bonds are vulnerable to inflation. But they claim that bonds make up for their inflation risk by providing a hedge against deflation (that is, a widespread drop in commodity prices and the cost of living).

That’s a theoretical advantage, but it’s of negligible value. Under today’s fiat-money system, which lets central banks create new money out of nothing, inflation is about 100 times more likely than deflation. When governments get deeply indebted, as many are these days given COVID-19 stimulus spending, they usually inflate their way out of their debt problems. That is, they pursue policies that spur inflation.

That’s why we haven’t bought bonds for a number of years, except on client instruction.

If you want to hold individual bonds, we recommend holding only short-term bonds, with terms of three years or less to maturity. These expose you to less risk of capital losses if interest rates rise.

We will continue to stay out of longer-term bonds and instead focus on well-established, dividend-paying stocks that meet our Successful Investor criteria. They are inherently more volatile than government bonds. But they expose your purchasing power to less long-term risk than bonds, they provide higher current yields, and they offer a hedge against inflation. It’s an easy choice for investors.

Caution is often warranted in the bond market. How frequently does the threat of inflation keep you out of it?

Do you invest in bonds? What do you find attractive about them?