Friday, July 15, 2016

The Case for Avoiding Bonds During Disinflationary Environments

This post will highlight that what matters over the longer term is the level of inflation over the entire life of the bond (rather than the current inflation rate).

To drive this point home, the chart below outlines the ten year realized real yield of a ten year treasury (the nominal starting yield less the inflation rate over the forward ten years), as well as the realized real yield assuming the current 1.6% yield was the starting yield over each of these periods (going back 140 years).

It may be surprising to learn that the real realized yield was above 0% (i.e. treasuries provided a positive real return for an investor) in ~75% of these rolling ten year periods vs ~25% if each period had a starting yield of 1.6% (those numbers are ~80% and 0% - not once - assuming rates had started at 1.6% over the last 50 years). What may be more surprising was that the best time to have purchased bonds historically was when there were higher levels of inflation present. The chart below outlines the historical (i.e. backward looking) ten year inflation rate (x-axis) against the forward ten year realized real yield (y-axis).

Why have bonds been a better buy when historical inflation was high and worse when historical inflation was low or negative?

Similar to how the market is currently pricing in record low yields given the view of low inflation over the next ten years (likely based upon the low inflation we have experienced over the most recent ten years), the market has historically repriced the yield of Treasuries much higher when we've experienced high levels of recent inflation. Thus, when inflation mean reverted higher from low levels / lower from high levels, the rates (in hindsight) did not properly reflect the forward inflation environment. If we were to look at the predictive power of 30 or 40 year bonds, the predictive power would be even worse (good luck with that 0% yielding Japanese Government Bond).

Thus, despite the low level of historical inflation, current (historically) low levels of nominal yield suggest that bonds are in fact likely as wretched a long-term investment as they seem.