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Learning to live with a dismal outlook for bond returns

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Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

The bond market has been on a multidecade bender. But the party is close to an end and the hangover could last for years.

The fun got started when interest rates were sky high in 1981 and bond prices bottomed out. (As bond prices go down, yields go up and vice versa.) Bonds had a hideous reputation at the time because they had failed to keep up with inflation for decades.

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But the brave souls who loaded up on long-term bonds made out like bandits. Long Canadian bonds gained an average of 11.2 per cent annually from 1982 through 2015 and they bested the Canadian stock market, which climbed 8.7 per cent annually over the same period.

Falling rates propel bond returns and the fall was dramatic. The yield on long-term federal government bonds hit 18.1 per cent in September, 1981, and subsequently declined, in an irregular fashion, to just 1.8 per cent last week according to the Bank of Canada. (Shorter-term government bonds currently have even lower yields.)

If you hold a bond to maturity, your gains should be close to its yield to maturity with small variations depending on the rate at which the coupons are reinvested. As a result, government bonds will likely provide annual returns of less than 2 per cent until they mature and that doesn't include fees, taxes and inflation. The low return rate doesn't provide much of a margin of safety.

History teaches investors a few lessons about bonds. Leaf through the Credit Suisse Global Investment Returns Yearbook for 2016 (you can Google it) and you'll quickly come to the conclusion that bonds aren't as safe as they're cracked up to be. Bonds generated small, or even negative, real returns in many countries from 1900 to 2015. While it is true that the two World Wars were particularly hard on bonds (and the people) in many affected countries, there were also long stretches in peacetime when bonds proved to be poor investments.

In Canada, bonds basically broke even in real terms from 1900 to the early 1980s with some variation along the way. They lost ground during the First World War, bounced back and climbed until the late 1940s, and then declined through to the early 1980s. Including the bull run of recent decades, Canadian bonds gained an average of 2.3 per cent annually from 1900 to the end of 2015 after adjusting for inflation.

While the outlook for bonds isn't great, they could advance in the near term should bond yields fall further. Yields might even turn negative as they have in other parts of the developed world. But the long-term upside for bonds appears to be modest at best at this point.

Regrettably, there isn't much that investors can do about the situation other than live with reduced returns.

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Interest rate risk can be reduced by lowering a portfolio's duration. That is, opting for shorter-term bonds, higher interest savings accounts, and the such. Problem is, the yields offered by these instruments are tiny.

Iron-willed investors might think about bailing out of bonds and into stocks. Unfortunately, it is doubtful that the majority of investors could do so with equanimity. Those with the will to do it might follow the instructions Warren Buffett has left in his will for managing his wife's portfolio. A tenth of her portfolio is to be invested in short-term government bonds and the remainder in a very low-cost S&P 500 index fund. (Canadians should probably opt for a blend of low-cost market-tracking index funds that follow Canadian, U.S., and international stocks.) But such a stock-heavy approach would cause too many sleepless nights for most investors.

Alas, most of us will simply have to plan for, and deal with, low bond returns, which likely means saving more and spending less.

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About the Author

Norman Rothery, Ph.D., CFA, is the founder of StingyInvestor.com and has been catering to value investors since 1995. He publishes the Rothery Report, a value stock newsletter. Norm obtained a Ph.D. in atomic physics from York University before following his passion for investing. More

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