Befuddled Bond Bears

Apparently we're in the midst of a "three year bear market" in bonds. We had no idea! Really, this is news to us. Actually, bond investments on a total return basis over the past years are positive. Lackluster, yes. But positive nonetheless. Here's what 10-year US Government Bond Total Returns look like:

2004 4.6%
2005 3.2%
2006 2.4%
2007 (YTD) 1.8%
Source: Global Financial Data

Certainly not what we'd call a bear market. In 2003 bonds were flattish, and the last time bonds actually dropped was 1999, with an 8% decline. Long interest rates are lately on the rise, but such moves of this magnitude are very common. (See our past commentaries, "Yield Mandala" and "Runaway Rates?".) The fact is, rates just haven't risen enough yet to make bond investments lose much ground. For goodness sake…the total return for bonds is still positive for 2007!

Probably the reason for the misunderstanding is folks commonly forget to account for coupon payments as a component of bond returns. Coupons, just like dividends for stocks, are a vital part of return on investment. It doesn't make sense to observe that interest rates are marginally higher and conclude bonds have a negative return. Price return is only a part of the equation!

When you look at shorter-term rates, like 3-month T-Bills for instance, you're even less likely to lose money. That's because most of the time 3-month bond investors don't resell the bonds, they just reinvest every 3 months when the term expires. But that's not exactly a strategy that boasts big returns.

Let's be clear: MarketMinder believes stocks are currently a superior investment to bonds …far superior in fact. Stocks today offer better relative value and even have tax advantages. Don't forget bond returns get ravaged by taxes—coupon payments are generally taxed as ordinary income. And the effects of inflation can indeed turn meager bond returns negative too.

The point is, contrary to popular spin, bonds are in nothing resembling a big bear market right now. This myth is coincident with the inane idea credit markets are set to implode. With US 10-year bonds below 5.1% (as of today's close) and credit markets showing no signs of broad stress, we're just not seeing the need for a big fuss right now.

We can understand the angst—the bond guys have got to be frustrated with the middling returns over the last few years. But then again, it's their fault for putting their money with an inferior asset class in the first place! Don't let their suffering befuddle you. Bond markets aren't imploding.