Guess who just got back today

Them wild-eyed boys that had been away

Haven’t changed, had much to say

But man, I still think them cats are crazy

The boys are back in town —Thin Lizzy

Government bonds: The gift that (usually) keeps on giving

Historically,

bonds

have provided investors with two main benefits. First, their yields have provided a reasonable, if unspectacular return. Second, they have offered diversification value, muting overall portfolio losses during

bear markets.

By owning high quality bonds, you got paid for protecting your portfolio during times of market turmoil, which is akin to receiving (rather than paying) a premium for fire insurance — a remarkably sweet deal indeed.

However, these benefits have historically ranged from significant to nonexistent, depending on the investment environment.

A bear market sedative

As the accompanying table illustrates, in five of the six equity bear markets before that of 2022, bonds provided investors with much needed gains, thereby mitigating the overall damage to their portfolios.

During the tech wreck of the early 2000s, a balanced portfolio that was 60 per cent weighted in the

S&P 500

and 40 per cent weighted in seven- to 10-year

U.S. Treasuries

declined 16.41 per cent, as compared with a fall of 42.46 per cent for the all-stock portfolio. In the global financial crisis (GFC) of 2007-2009, the balanced portfolio lost 23.92 per cent versus a loss of 45.76 per cent in equities.

The ZIRP era and the erosion of bond powers

During the GFC, central banks entered hyper-stimulus mode to stave off a collapse of the global financial system and avoid a worldwide depression. ZIRP (zero interest rate policy) stances became the norm for monetary authorities around the world, with rates remaining at historically low levels for the next 14 years.

Although stimulative policies were successful in making the recession less severe than would have otherwise been the case, they also robbed bonds of their two key attributes. First, high quality bonds ceased to offer reasonable yields. Second, ultra low rates also limited the ability of bonds to provide capital gains during times of equity market turmoil, thereby hindering their diversification value.

In 2016,

Pacific Investment Management Co.

co-founder and “Bond King” Bill Gross commented that to repeat the bond market’s 7.5 per cent annualized return over the past 40 years, yields would have to drop to negative 17 per cent. The math just didn’t work.

A clear warning sign

As the saying goes, “Hindsight is 20/20.” It is easy to understand what should have been done after an event has already happened, even if it was not obvious at the time. However, market behaviour during the COVID crash offered a clear warning that all was not well in bond land.

The accompanying table compares countries by their pre-pandemic short-term rates and the returns of their 10-year government bonds during the subsequent bear market.

There is a near perfect relationship across countries in terms of where their short-term rates stood prior to the pandemic and the subsequent return of their 10-year bonds.

  • In the countries that initially had relatively high short-term rates, such as the U.S., Canada and Norway, 10-year bonds produced substantial gains and mitigated the damage caused by the vicious decline in stocks.
  • In countries that started with rates that were neither relatively high nor low, such as the U.K. and Australia, 10-year bonds provided some, albeit lower, amounts of protection.
  • Lastly, in countries that started with the lowest rates, such as Sweden, Japan, Germany and Switzerland, not only did government bonds fail to mitigate stock losses but their returns actually declined.

Given the strong correlation between where pre-COVID rates stood in different countries and the subsequent ability of their bond markets to offset

stock market

losses, it was clear there was little, if any, gas left in the tank in the post-COVID world of zero rates, leaving investors largely unprotected.

From hedge to Texas hedge

Post-COVID, not only did ultra-low rates obliterate the insurance value of bond holdings, but the unprecedented amounts of monetary and fiscal stimulus that had been injected into the global economy left bonds particularly vulnerable to capital losses. Against this backdrop, when the rubber of stimulus hit the road of inflation in early 2022, central banks were forced to raise rates at a clip not seen since the Volcker era of the 1980s, resulting in painful declines in bond prices.

  • Canadians snap up most U.S. bonds since 2023
  • TD Bank uses automation to trade more bonds

In livestock trading, a Texas hedge refers to a scenario where cattle ranchers buy cattle futures contracts despite already owning cattle, thereby doubling their risk exposure. In 2022, when fears of a Fed-induced recession caused stock prices to tank, bonds not only failed to provide diversification but acted as a Texas hedge, declining alongside stocks. From early August 2020 through late October 2022, the Bloomberg U.S. Aggregate Bond index suffered a peak-trough loss of 18.5 per cent.

Bonds are back in the game

Following the most significant rate hiking cycle in decades, bonds are once again “back in the game.” They offer reasonable yields, thereby restoring their prospects for delivering moderate returns, decreasing their risk and enhancing their diversification value. Given these resurgent qualities, bonds once again constitute a valuable component of many investors’ portfolios.

Noah Solomon is chief investment officer at Outcome Metric Asset Management LP.

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