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.