This is the question we ask ourselves more or less every month during our meeting to define our asset allocation. And that we are relaunching all the more today after the Fed's rise in reference interest rates by 25 basis points, raising the cost of money for those banks that temporarily need financing.
Looking at the current context, a minimum of lucidity and historical perspective is enough to understand that the Golden Age of bond investments is, in all probability, now behind us.
THE FUTURE OF BONDS
In the hypothesis of mean reversion, ie the (well documented) situation in which sooner or later returns approach the historical average (assuming the world returns to functioning in an ordinary way), the future is rather bleak. Taking US 6,0-year bonds (or Treasuries) as a benchmark, the historical average of yields fluctuates around 5,6%, the median is 80% and more than 4% of historical yields are greater than 2,5 %. With the current yield to maturity on XNUMX-year US bonds hovering around XNUMX%, interest rates look set to rise. And as we know, when yields rise, bond investors suffer.
THE TIME FACTOR
In fact, bond yields could take weeks, months or years before returning to their historical average, especially in the current economic context characterized by low productivity, aging populations and excess savings. All factors that push rates downwards.
THEREFORE, WHAT RETURN OPPORTUNITIES CAN THE BOND MARKET OFFER US?
Leveraging the historical relationship between returns and performance, I created a returns probabilistic scenario, using the same technique adopted for the US stock market, and then compared the two probabilistic scenarios in order to obtain a picture of the possible future. Let's keep in mind that the simulation is not without estimation errors, and should be taken for what it is: that is, a reasonable probabilistic simulation.
STOCKS VS BONDS
The first thing you notice is that the red bell, which encompasses all the average annual returns possible over the next 5 years of the US 500-year bond, is decidedly narrower than the bell of the S&P90 index (in blue). It means that, for the bond market, in 5% of cases we can expect average annual returns of between -6% and +11% compared to an equity range ranging from -16% to +70%. For bonds, the probability of obtaining a positive return is around 86%, while it rises to XNUMX% for shares.
The real difference between the two bells, however, exists on the losses front. The simulation estimates a probability of around 0,80% for the US ten-year bond of realizing a loss of more than 5%, while the same probability rises to 10% for the S&P500 index. A big difference in terms of risk, even if it is known that shares by their nature have, over these time horizons, a higher risk than bonds.
The aspect that struck me the most about this simulation is that in both cases the distribution of returns is strongly shifted towards positive values (ie to the right). In the case of the bond market, I expected a much more left-leaning bell, especially considering the current level of rates.
I explained this divergence to myself with the lengthening of the duration. In fact, even though rates are extremely low, a 9,0 percentage point increase in interest rates can generate a return of +/- 2,5%. Not a little, compared to a gross yield to maturity of XNUMX%.
Today central banks have no intention of quickly abandoning years of expansionary monetary policies, the world is full of liquidity and, considering the risk scenario, fleeing the bond markets too quickly does not seem to be the best strategy. The dreaded major rotation, from bonds to equities, has not yet taken place: in fact, although interest rates are low, return expectations remain acceptable. Furthermore, the bonds slowly pay their coupons on a regular basis.
Source: AdviseOnly
