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After a 35-year rally, bonds are heading for trouble

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Portfolio statements should come with a warning, one that says a big chunk of your portfolio is unlikely to produce a penny in profit. This cautionary statement wouldn't need to be based on some radical call about where the economy is headed. All it would have to do is explain the depressing math behind today's bond market.

At current prices, a diversified basket of Canadian bonds produces a yield to maturity of barely 2% a year. Take into account the bite of inflation, as well as the steady erosion produced by fees if you hold a bond fund, and the best you can reasonably hope for is to break even in real terms. Oh, and that's before paying taxes on the paltry interest income that does trickle into your pocket.

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Given that ugly reality, bonds look like the worst proposition this side of a vacation in Aleppo.  Yet they continue to make up a third to a half of many portfolios. It's a situation that should make investors scratch their heads. Why devote so much money to something that will struggle to simply maintain its current value?

Many financial advisers respond that bonds aren't in your portfolio to make a big return; they're there to buffer you if the stock market crashes. Fair enough: If Bay Street and Wall Street tumble tomorrow, you'll be glad about your bonds, even if they don't generate any profits.

However, that logic assumes bonds are safer than stocks. It may be time to re-examine that proposition.

Paul Schmelzing, a doctoral candidate at Harvard University and visiting scholar at the Bank of England, recently looked at eight centuries of bond market smackdowns and concluded that another bloodletting in the fixed-income market is highly likely. "History suggests this reversal will be driven by inflation fundamentals and leave investors worse off than the 1994 bond massacre," he wrote in January.

In large part, the bond sell-off will be a reaction to yesterday's excesses, notably the long downward slide in key interest rates since the early 1980s. The past 35 years "constitute one of the most remarkable periods in economic history" for the world's risk-free asset of choice, Schmelzing says. Not since the 16th century have benchmark bond yields marched steadily downward for so long. Never in 800 years have they hit the lows that U.S. treasuries hit last year.

All that sets the stage for a bloody reversal. If inflation shoots up in the years ahead, surging interest rates will hammer bond investors, because bond prices move inversely to rates.

Schmelzing blames the coming debacle on central bank policies, notably quantitative easing, that have encouraged investors to misprice the risk involved in holding long-term government bonds. He argues we're now in a period similar to the last half of the 1960s, when the U.S. government opened its wallet to finance the Vietnam War despite a labour market already at full employment. Inflation soared in response; so did interest rates. "With-in four years, bond investors lost an aggregated 36% in real terms," he says.

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President Donald Trump's promises to goose an already tight U.S. labour market could have a similar impact. Automated "value at risk" bond trading programs might amplify the effect if they prod banks to start dumping their bonds once rates start moving up.

So should you rush out of bonds now? Despite Schmelzing's impressive research, I'm not entirely convinced. History may not apply in a global economy built on fiat currencies overseen by powerful central banks. It's possible we're in a new era in which returns on all assets will be lower than in the past. If so, you may not benefit much by jumping out of bonds and into real estate or stocks.

Still, it seems reasonable to limit your exposure to what might lie ahead. Stick to bonds that mature in five years or less, because they will be hurt less than longer-dated bonds if yields shoot upward. Also, consider cash and reasonably priced stocks as bond alternatives. If this is a massive bond-market bubble, as Schmelzing argues, you need buffers against the carnage ahead.

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About the Author

Ian McGugan is a reporter with The Globe and Mail's Report on Business and has been writing about investing, economics and business for more than 20 years. He joined the Globe and Mail in 2010. He has been executive editor of Canadian Business magazine and founding editor of MoneySense magazine. More

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