Bond yields and asset allocation

Allocating some percentage of your portfolio to bonds is a common practice that also theoretically makes sense: bond returns are inversely correlated with equity returns, creating a portfolio with a lower variance and better risk-adjusted returns. I don’t own any bonds though, because with the current low yields it’s hard to imagine that it is going to generate positive returns in the long run.

GMO publishes a monthly asset class forecast that mainly assumes that in 7 years time valuations return to long term averages. This simple approach correctly predicted poor long-term returns during the dot-com bubble and high returns in the middle of the financial crisis. Mean reversion does not bode well for the future of bond owners:

This is of course no rocket science. When some governments are selling 2 year bonds with a negative yield you can’t really expect positive returns after inflation. Instead of risk-free returns government bonds are giving return-free risks (don’t know who coined this term originally, but it’s a nice description for the current situation).

Bill Nygren’s OakMark seems to have the same view:

The 30-year U.S. Treasury Bond today yields about 2.7%. Just 10 years ago, its yield was 5.8%. If five years from now the yield simply returned to its level of a decade ago (and just in case you think I’m cherry picking, over the past 25 years it has averaged a 7.5% yield and at the low in 1981 was twice that), bond investors would suffer a meaningful loss of capital. The principal of the bond would decline by 43%, which would swamp the 14% interest income received over five years, leaving a total loss of 29%. That’s a high price to pay for reducing a portfolio’s risk level.

Contrast that to the S&P 500, which yields just a fraction of a percent less than the bond and we expect will grow earnings at about 6% per year for the next five years. If that growth rate is achieved, the current P/E multiple of 12.9 times would have to fall to 10 times for the S&P price to stay unchanged. The P/E would have to fall to about 7 times to match the loss that the bond investor would sustain if yields reverted to their decade ago level. With a historical average P/E of about 15 times, a 7 times multiple seems like quite an outlier.

A final note: in a lot of cases small individual investors would be crazy to buy government bonds. I’m Dutch, and our government just sold two year bonds today with a 0.003 percent yield. At the same time it is possible to park money in a CD for two years and receive a ~3.3 percent yield. Since this money is also guaranteed by the government (up to 100.000 euro) it would be stupid to park it in lower yielding bonds.

15 thoughts on “Bond yields and asset allocation

  1. JRV

    The difference between dividend yields and bond yields is quite big.

    Can you go long on bond yields and short dividend yields as a pair trade?

    Like that you win once the gap narrows.

  2. JRV

    What I mean is that the difference between dividend yields and bond yields is quite big now.

    So going long on Treasury yields (which are negative in real terms) while shorting Stock yields should be interesting.

    I know there are future dividend yield products in Europe. I have them via Interactive Brokers. So you can bet if yields will go up or down from here to 1 or 2 or 3 or more years. As of now European dividend yields are still quite big.

    So shorting dividend yields while going long on Treasury yields looks interesting: Like that you win once the gap narrows so when bond and stocks yields approach each other.

    Makes sense to you?

    1. Alpha Vulture

      You’re not making a lot of sense to me, sorry! The difference between bond yields and stock yields isn’t very big, and that’s exactly the reason why bond yields aren’t attractive: stock yields will probably continue to grow in the future while the bond yield is a constant.

      1. JRV

        Hi thanks for the reply.

        To clarify: I’m betting on sovereign bonds, in the future, to yield more in relation to stock dividends.

        European stocks are yielding more than twice (4/1.5) as much as bonds, almost 3 times. 10 year US treasuries at 1.5 and dividend yields on European index are at 4%.

        I think bond yields will go up in relation to stock yields. So bond yields will go up to for example 2.5 and stock yields down to for example 3%. So the stocks would just yield more than bonds but not more than twice times more

        It doesn’t matter if treasury bond yields stay flat, which I doubt anyways. As long as dividend yields go down you could win. Or even if dividend yields stay flat and bond yields go up you could win. Only way to lose would be if Treasury yields go to 1 or 0 and stock dividend yields go to 5% (so stocks pay more dividends in relation to their price), which in both cases I also seriously doubt.

        My question was if you knew an instrument where you could bet on stock dividend yields, not what you think will happen.

        I already found how that can be possible, there are futures for dividend yields on European indexes accessible via my broker. As for treasuries I can short 10 year treasury bonds.

        1. Alpha Vulture

          I don’t think dividend futures are the right tool for the job: the dividend yield can also go up and down based on the price of the stocks, not because the dividend is going up or down.

          I would also look at the carrying costs of the trade: that could also eliminate potential profit.

          1. JRV

            “the dividend yield can also go up and down based on the price of the stocks, not because the dividend is going up or down.”

            of course, that’s the definition of yield

            So for example if a simple bet on stock yields going down is:

            Sell an equal amount of dividend futures and short the index. If the yield goes down in relation to the value of the stocks you win.

            Naturally you always nee to consider transaction costs.

            Can you please post your performance evaluation, if possible like this:

            For the last year a year to date evaluation will do. For previous years, I prefer total return if you have it.

            You may send it to my mail if you do not like to show your results publicly.


  3. kroeliewoelie

    Bonds =! Dutch/German/American treasuries. There are others out there… have you considered those?

    I agree with your point that it makes no sense to invest in Dutch treasuries as long as you can easily using higher yielding savings products covered by deposit insurance. (The perks of being small are nice 🙂 )

  4. Alpha Vulture

    Treasuries are imo a subset of bonds. And sure, there are other bonds/treasuries, but don’t think there is an obvious choice if you want a decent yield: you’re not going to get it without risk. And the higher yielding bonds also have often a positive correlation with the equity markets, reducing the value of diversification.

  5. pietje

    But seriously, investing in german / dutch / american bonds now is close to retarded imo. Shorting the stuff is also scary, so I just leave them alone. Prob the best way to short the bond market is to buy a nice house with a fixed mortgage @ 4% and watch the bank suffer when real interest rates start to rise again.

    1. JRV

      I understand the ones investing in german / dutch if they think that the euro will collapse and those treasuries will be transformed to their local currencies and rev-evaluate immensely respect other currencies. I’m not saying that the euro will collapse, but If a had a strong conviction it would investing there would make more sense.

      1. JRV

        then again in such scenario leaving your money in the bank would even safer at least you avoid the risk of losing principal if inflation comes

        I put my money in a Rabobank account in Belgium, maxi-spaar or plus account (dont remember now), I do remember that it’s a 2.5% interest rate, not bad to park cash. And if the euro disappears and we go back the francs I don’t care really. Better than dollars or pesetas if you ask me.


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