Many retail investors avoid the bond market because it does not offer the same upside potential as the stock Exchange. Although the bond market is different from the stock market, it should not be ignored. It is comparable in size to the stock market and has enormous depth.

Triumph Of The Optimists: 101 Years Of Global Return On Investment, a 2002 book by Elroy Dimson, Paul Marsh, and Mike Staunton, can help us revisit bonds in the 20th century. We then examine the impact of innovation. Finally, we will look at bond market returns over the first two decades of the 21st century.

A Wicked Century for Bond Investors

Equity investors triumphed over bond investors during the 20th century. The risk premium builds in bonds during the 1900s were far too small to compensate investors for the turbulence to come. This period was marked by two secular bear and bull markets for US fixed income securities. Inflation peaked at the end of World Wars I and II due to increased government spending during those periods.

The first one bull market began after World War I and lasted until after World War II. According to Dimson, Marsh and Staunton, the US government maintained the link given artificially low during the inflationary period of World War II and until 1951. It was not until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term US bond yields then climbed to a high of 15% in 1981. This was the turning point of the second bull market of the century.

The graph below shows the reality government bond returns for the 20th century. All countries listed in the table below have shown positive results actual returns in their stock markets during this period. Ironically, the same could not be said for their bond markets.

The countries that posted negative real returns were those most affected by the world wars. For example, Germany has had two periods in which fixed income was virtually wiped out. During the worst of the two periods, 1922-23, inflation reached the unfathomable figure of 209,000,000,000%. According Triumph of the Optimists, 300 paper mills and 150 printers with 2,000 presses worked day and night to meet the demand for banknotes during this period. The 20th century has known more than one episode of hyperinflationbut that experienced by Germany in the early 1920s was particularly severe.

The chart below compares real government bond yields for the first and second half of the 20th century. Notice how countries that saw their bond markets do very poorly in the first half of the 20th century saw their fates reversed in the second half:

This illustration gives you a good idea of ​​the government bond market. According to Dimson, Marsh and Staunton, the United States corporate bond the market also behaved better. US corporate bonds added an average of 100 basis points above comparable government bonds during the 20th century. They calculated that about half of this difference was related to the default premium. The other half is related to defaults, downgrades and early calls.

The bond market would never be the same again

In the 1970s, the globalization global markets has started again in earnest. Not since the Golden Age had the world seen such globalization, and it would really start to impact bond markets in the 1980s. Until then, retail investors, mutual funds and foreign investors did not represent a significant share of the bond market. The article “Fixed income management: past, present and future” of Daniel Fuss provides useful analysis.

According to Fuss, the bond market saw more development and innovation in the last two decades of the 20th century than in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset backed securities (ABS), mortgage-backed securities, high yield securities and catastrophe bonds have been created. Early investors in these new securities were rewarded for taking on the challenge of understanding and evaluating them.

The impact of innovation

The bond market entered the 21st century after experiencing its biggest bull market. Long-term bond yields fell from a high of 15% in 1981 to 6% by the end of the century, driving bond prices higher.

Bond market innovation also increased in the last three decades of the 20th century, and this is likely to continue. Otherwise, securitization can be unstoppable, and anything with significant future cash flows is likely to be turned into ABS. Healthcare claims, mutual fund fees, and student loans, for example, are just a few of the areas being developed for the ABS market.

Another likely development is that derivatives will become a larger part of institutional fixed income. The use of instruments such as interest rate futures, interest rate swaps and credit default swaps (CDS) will likely continue to grow.

Based on issuance and liquidity, the United States and the Eurobond maintain their dominance in the global bond market. As bond market liquidity improves, exchange traded funds (ETF) will continue to gain market share. ETFs can demystify fixed income investing for the retail client through simplified trading and increased transparency. For example, BlackRock’s iShares website has daily data on its bond ETFs.

Finally, continued strong demand for fixed income securities from companies such as pension funds will only contribute to accelerating these trends over the coming decades.

Bonds in the 21st century

The bond bull market has shown continued strength at the start of the 21st century, but this strength challenges the future. During the first decade of the 21st century, bonds surprised most observers by outperforming the stock market. What’s more, the stock market posted extreme results volatility during this decade. The bond market, on the other hand, remained relatively stable, as shown in the chart below.

Stocks returned to their dominant position in the second decade of the 21st century. However, bonds continued to produce substantial returns. In particular, the broader US bond market rallied impressively for much of 2019, as Federal Reserve (Fed) lowers interest rates.

However, lower interest rates ultimately mean lower bond yields in the future. Outside the United States, negative bond yields have already become normal in Germany and Japan. Negative-yielding bonds are guaranteed to lose money in the long run.

The COVID-19 pandemic has had a dramatic impact on humanity and disrupted global financial markets. Bond markets were not spared as the economic turmoil dramatically increased volatility to levels not seen since the Great Recession of 2008.

Treasury bond yields plunged to historic lows as investors sought refuge in the safety of US Treasuries. Buoyed by the Fed’s quick reaction to inject liquidity to support the financial system, the bond market outperformed the stock market for most of 2020. However, stock markets made a strong comeback at the end of 2020 with nominal returns higher than those of bonds.

The essential

In most cases, investing in fixed income securities in the last century was not too lucrative a proposition. Therefore, the current fixed income investor should demand a higher risk premium.

If this happens, it will have significant implications for asset allocation the decisions. Rising demand for fixed income will only spur innovation, which has taken this asset class from sluggish to fashionable.