longinvest wrote: ↑
Sat Dec 09, 2017 7:39 pm
First, for investors really worried about inflation, there now exist inflation-indexed bonds (TIPS) and inflation-indexed cash investments (I-Bonds).
Second, I think it's important to deconstruct an investment myth: that nominal bonds are vulnerable to inflation. Things are not as simple as a quick glimpse at an inflation-adjusted growth chart could lead one to think. One has to go beyond the chart and understand what happened in the real world and the choices a bond investor could have made at the time.
nedsaid wrote: ↑
Sat Dec 09, 2017 4:31 pm
Inflation spikes are tough on most things except for maybe commodities. Bond investors, according to Bill Bernstein, lost about 50% of purchasing power from about 1946-1982.
Actually, the only worrisome bond losses happened in the 1940s and early 1950s, because interest rates were subject to price controls and interest rate pegging
* **. In other words, during a period when inflation went, sometime, near 20%, the government forced all interest rates (short-term to long-term) to remain low near 2% to 3%. During this period, a 10-year ladder-like bond fund (selling its bonds on the market 1 year prior to maturity) would have lost almost 35%, in inflation-adjusted terms. And that was it. It was a one-time
government-caused loss of purchase power.
* Interest Rate Controls: The United States in the 1940s on JSTOR
** Before the Accord: US Monetary - Fiscal Policy 1945 -1951
due to free
bond market pricing. The bond market wasn't
allowed to set prices normally by devaluing bonds (due to high inflation) which would have caused yields to immediately spike. Losses were due to deliberate government action to keep bond prices high (yields low). But, here's the important point
: The bond investor was perfectly aware of the situation at the time. He knew that money left into bonds was losing purchase power. He had the ability to act. The bond investor could have accepted the government's offer to buy back his bonds at a 2% to 3% yield to maturity in a high-inflation environment and invest his money elsewhere.
The bond investor didn't have to accept low yields in a high-inflation environment. Of course, the question was: Where to invest it? Cash had lower yields than bonds, so it was no refuge. Private gold possession was outlawed since 1934. I guess that left little choice other than to invest the money into real estate and stocks.
Here's a chart I've shown, recently, in another thread:
longinvest wrote: ↑
Tue Dec 05, 2017 11:15 am
Here's a historical inflation-adjusted bond total-return chart for 1940 to 1985:
(Source data for constructing the chart: VPW backtesting spreadsheet)
We see the loss of purchase power in the 1940s, due to yields significantly trailing inflation. We also see a few years dip, in the late 1970s, when inflation was raging up and yields were following up. As expected, it took a few years lag for the impact of higher yields to be fully reflected into total returns; nothing surprising, here. What's actually surprising is how yields kept a big spread over trailing inflation afterwards, explaining a gain equivalent to the losses of the 1940s in a few years, in the early 1980s. My point is that both events are completely unrelated. There was a government-imposed real loss in the 1940s. In the 1980s, bond investors became very demanding for higher yields.
The government finally allowed the market to price bonds normally since 1952. If we look at the above chart starting in 1952, we see that nominal bonds did preserve their value on a total-return basis, in inflation-adjusted terms, and even gained additional purchase power over inflation. There was a dip in the second half of the 1970s, due to bond yields going continuously up, adjusting for inflation. As bond math tells us, this was normal. The higher yields explain the surge in total returns that followed.
In the 1970s, bonds actually did better than stocks; they were less volatile and yet delivered almost as much in returns. Here's a chart I've shown in another thread that makes this pretty obvious:
longinvest wrote: ↑
Fri Aug 26, 2016 8:46 am
Just for reference, here's a total-return
chart I made, on another thread, to show the comparative growth of an intermediate
-duration ladder-like bond fund and the S&P 500 in the worst high-inflation part of the 1970s to mid-1980s:
By looking at a nominal
chart, we can clearly see that all along, the bond fund had positive annual total returns. The S&P 500 (with dividends reinvested), on the other hand, did as it always does, it fluctuated. In 1973-1975, it had a big down fluctuation, losing 30% while inflation was going up 20%, for example.
We're almost never shown such charts. Usually, the nominal fund returns are combined with the impact of inflation and we're shown inflation-adjusted charts, leading to the impression that bonds are volatile. This impression is compounded, of course, when long-term bonds (which are
volatile) are used to represent bond returns.
People invested in intermediate bonds, during the above period, just saw an increasing portfolio balance on their annual statements, unlike stock investors who didn't fare much better, in the end, over that period.
In summary, I think that nominal bonds are way less risky than often portrayed. What's actually risky, for nominal bond investors, isn't inflation
; it's to leave money into nominal bonds when their yields are way below current inflation... assuming that one knows of a better place where to put the money, of course...