Burton Malkiel: Bond buyers should be mindful of history

Prof. Malkiel has been for three months CIO of Wealthfront. His recommendations are now being integrated into much-expanded asset classes, managed by the Wealthfront software for 0.25% management fee. Of special interest to the retired cohort is what to do about the negative returns offered by bonds? In this FT essay Malkiel first outlines the history of what happened to bond holders the last time Treasury yields were 1.5% in 1946:


But does this flight to so-called havens really provide investors with the protection they desire? Or, are bond buyers making a huge mistake that is likely to guarantee them a period of negative real (after inflation) returns? The answer is almost certainly the latter. Bonds today in countries such as Japan, Germany, and the US are more expensive than at any time in history. Bond investors face virtually sure losses and equities are as attractive as they have been in a generation.

We can illustrate the fundamental unattractiveness of bonds with the US market. The buyer of a 10-year US Treasury bond at a 1.5 per cent yield to maturity will receive a nominal return well below the current rate of inflation and below the Federal Reserve’s informal target rate of inflation of 2 per cent. Thus, even if inflation does not accelerate, long-term US Treasuries will provide a negative real rate of return. If inflation does accelerate, that real rate of return will be further reduced.

It is important to remember what happened to bond investors the last time that Treasury bond yields were at 1.5 per cent, in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance the debts from the second world war. Therefore, bond prices remained fairly stable. But moderate inflation reduced the real value of both coupon payments and the face value of the bonds, and bondholders lost considerable purchasing power. And that was only the beginning of the pain.

Interest rates began to rise to more normal levels and bond prices started to fall. Oil and food shocks then boosted inflation further and, by the end of the 1970s, bond yields had increased to double digit levels. Thus, bond owners not only earned negative real income returns but also suffered punishing capital losses. No wonder a “bond” came to be considered an unmentionable four letter word and bond investors came to believe they had in effect been slaughtered. Investors should be mindful of history. The current era of financial repression may well lead once again to the euthanasia of the bondholding class.

All the developed countries of the world are burdened with excessive amounts of debt. As in the US, governments around the world are having an extraordinarily difficult time reining in entitlement programmes in the face of ageing populations. The easier path for the US government is to keep interest rates artificially low as the real burden of the debt is reduced and the debt is restructured on the backs of the bondholders. We reduced the debt to gross domestic product ratio in the US from 122 per cent in 1946 to 33 per cent in 1980. But it was achieved at the expense of bondholders.

Equities are reasonably priced and are downright cheap in comparison with bond alternatives. (…) 

Emerging market equities are even cheaper. (…) 

If you are a retired saver you should have a profound grasp of the meaning of financial repression by now. Please read the full Malkiel analysis at FT.

Wealthfront has added five new income-producing asset classes to improve bond diversification as follows:

  • Municipal Bonds
  • Corporate Bonds
  • Treasury Inflation Protected Securities (TIPS)
  • Emerging Market Bonds
  • Dividend Growth Stocks

Each asset class has a different set of risk, return and tax characteristics, so adding them gives us more ability to customize portfolios. Not every account will include all of the 11 asset classes we now use; a different subset of the asset classes will be used depending on account type and each client’s tolerance for risk. To read more about the rationale behind our changes please see our blog post, Burt Malkiel On Wealthfront’s Promise.

1 thought on “Burton Malkiel: Bond buyers should be mindful of history

  1. Pingback: FW: “When You Get This Kind Of Rigging, It Will End Badly” – Marilyn & Alan |

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