Everybody knows that stocks are riskier than bonds. We agree with that, but like to present one chart to cast a little bit of doubt on that picture. Food for thought if you will, for the fact that in finance and personal finance (and most other places in life, for that matter) nothing is completely clear-cut all the time.
Monthly stocks returns are significantly more volatile than bond returns
In the plot below we see monthly (nominal) returns. Clearly, stock returns display more month over month risk evidenced by the wider dispersion of the blue line. Back in the 1930s, you saw the wildest monthly swings but even more recently, we can see all the spikes of October 1987, LTCM situation in 1998, DotCom crash in 2001 and Global Financial Crisis in 2008/9.
Bond returns (expressed as the returns of the 10-year US Treasury Benchmark Bond) had much lower dispersion, though risk has increased quite a bit since the late 1960s to early 1970s. Note that these are default-free US government bonds, so the volatility comes entirely from inflation shocks and interest rate moves (bond price goes down if yield goes up). Even High-Yield (junk) bonds with significant default risk or longer-term US government bonds (20+ year maturity), still have lower fluctuations in monthly returns than stocks. But we just happened to have the returns for the 10-year Treasury handy so we will do our analysis with this bond index.
All of this is true not just visually, but also when comparing the standard deviation of monthly returns (but expressed as an annual value as is common in Finance, i.e., multiplied by the square root of 12). Stock returns have been about three times as volatile than bond returns over the entire sample period (16.7% vs. 5.5%0, and about twice as volatile since 1987 (15.8% vs. 7.4%). What’s the significance of 1987? I like to look at the performance of economic and financial series in the Greenspan/Bernanke/Yellen Federal Reserve era, because the very early period may not be quite as representative for today’s asset returns. Recall, until 1913/14 we didn’t even have a Federal Reserve in this country, and even between 1914 and 1987, Federal Reserve policy was quite a bit different from today’s policy responses to economic shocks.
Bond returns can be very uncertain in the long-run
Let’s look at the chart below. It’s exactly the same data. The only difference is that we plot the cumulative return of $1.00 invested in 1871. To make it more comparable over time due to different inflation regimes we also plot this adjusted for CPI-Inflation. Notice that the equity portfolio would have grown to a staggering $11,000, and yes, this is inflation-adjusted (in nominal terms $1.00 would have grown to a mind-blowing $200,000+). With such massive growth we also have to look at this in a log-scale on the y-axis to be able to compare growth rates over time.
Still the same result, the blue line is more volatile than the orange. Of course, one “risk” of bonds is the lack of significant return over the very long run (2.6% p.a. compared to the 6.6% average real return for stocks). But the chart above reveals another potential risk of bond returns:
Bond returns seem to be very episodic with decade-long super-cycles
You can have many decades in a row of very strong returns, but also multi-decade phases of sideways or even strong negative real returns. There was an 80+ year time window from 1898 to 1981 when bonds had zero real returns. We consider that the mother of all risks! Bonds also had a 40Y return window with -2.08% average real return, compared to +2.62% as the worst equity 40Y return window. The Bond return upside is limited. Only under 5% real return over the best 40-Y window, compared to over 10% for equities.
In contrast to bonds, equities might have wild swings short-term or even over a business cycle, but equity cumulative returns have a tendency to revert back to that strong exponential trend (which shows up as a linear trend due to the log-scale on the y-axis) and that exponential trend has had an impressive growth rate of around 6.2% for the last 145 years. Quite intriguing how equity returns display cycles of greed and fear but always revert back to that trend.
When looking at the cumulative return chart above we see three phases of bond return super-cycles: up (green arrows), sideways or slightly down (orange arrows), down (red arrows). Zooming in some more on what happened during those phases, see the table below:
- During the high return periods (green), we see 6+% annualized real return. That’s because they coincide with low inflation and decreasing interest rates (recall, bonds generate capital gains when yields go down).
- During the low return periods (orange) we usually see an increase in bond yields and inflation.
- During the very low return periods (red) we see 5-10 years of very large increases in inflation and yields, with very bad bond returns outcomes.
- The bond super-cycles (a full cycle of one phase each, i.e., green, orange and red) can be as long as 75 years, e.g. 1941-2016! Equities, in contrast, revert back to their mean growth path much faster, usually within the length of a full business cycle of “only” 8-10 years.
So it seems that stocks and bonds are exposed to different risks to different degrees:
- Stocks have a lot of short-term risks, but in the long-term stock returns are tied to economic growth and thus, in the very long-term, real returns become less risky due to that
- Bonds have relatively little short-term risk around their trend growth rate, but their trend growth path itself has a lot of risk in stark contrast to stocks
It’s that second uncertainty, the one about long-term expected returns, where bonds seem to be riskier than stocks.
What explains this phenomenon?
Equities are tied to the real macroeconomy. Corporate profits drop during recessions, often many times more than GDP, which explains the overreaction in equity returns, but equity total returns will eventually catch up to their growth path, tied to the economy’s growth path.
Bonds on the other hand, while having low month-to-month volatility, can languish for many decades, usually during periods when inflation and interest rates rise. Being completely nominal financial instruments, if inflation and/or rate hikes wipe out your returns, there is no snapping back of your returns back to any real time trend. Your losses are baked in and permanent! It’s true that eventually you can get a good phase again, but that might be after many decades of low or negative returns. The total length of the orange and red phases was 19 years (1901-1920) and a whopping 40 years (1941-1981), almost an entire retirement.
Implications of these bond super-cycles are far-reaching
First, if the pattern we observed over the past 145 years continues, that’s a very bad sign for bonds right now. The current “green phase” of strong bond returns has already lasted longer than the other two and is due to turn into a lower return regime. It’s almost impossible to continue the trend growth rate of 6+% real returns observed over the past 35 years because nominal yields for 10Y government bonds are at 1.80% (nominal) while writing this. At 1.75%-2.00% expected inflation, it’s hard to see how you get even any positive real rate of return from government bonds. Of course, you could go for corporate bonds with higher yields, but you then introduce equity correlation through default risk. There’s no free lunch.
The other unpleasant implication from our results is that over the past 145 years, bond returns went through 3 very good sub-periods, but only 2 of the bad periods each. That means the average bond return over the cFIREsim simulation period (2.6%) is likely unsustainable in the long-term. Why is that? If you look at bond returns over one complete super-cycle (one green, one orange and one red period) you get a much lower average returns. For example for the past full that started in 1941 and has so far lasted 75 years, the average bond return was only 1.63% real, a full percentage point lower than the full sample average return. Ouch!
What risk matters most for retirees?
Of course, both types of risk matter. Short-term fluctuations in equity returns (especially negative ones) are poison in retirement. But if the drawdown is only temporary and equities are likely to snap back fast it may not sink your retirement. But for early retirees with a 50-60 year retirement horizon uncertainty about long-term expected returns is a big issue. When planning with a 3%, even 4% withdrawal rate, adding an asset with a potentially low or even negative decade-long real return trend, may be riskier than equities, at least in the long-term.
Do we have anything nice to say about bonds?
There’s an upside: Bonds have had a negative correlation with stocks for quite some time. The one way bonds can add a real boost to the portfolio is to buy them on margin. Say, you own a 100% equity portfolio and want to add bonds to the mix. Instead of selling equities to buy bonds, thereby incurring the steep opportunity cost of low yielding bonds, one could buy Treasury Futures and get the bond exposure without giving up the equity returns. That’s not for everybody and some people might find the use of leverage too scary. But in this case, the leverage is used to reduce equity volatility. Currently, we do a version of this, but we will defer the details to a later post.