Review of "100 Years of Corporate Bond Returns Revisited" 11 comments
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Deutsche Bank’s 100 Years of Corporate Bond Returns Revisited, by Jim Reid, Nick Burns, and Adekunle Ademakinwa, is much more than "Bonds - Just Bonds."
The 53 page document (the "Report") - filled with charts and tables - provides a comprehensive review of both nominal and real returns for US Corporate Bonds, Treasuries, Equities, Property, and Oil.
My much shorter review will focus on what I believe are the highlights of this "Fundamental Credit Special" that Deutsche Bank published on 5 November 2008, but you should obtain and read the complete Report. What follows, of course, are my views, and do not necessarily reflect those of either Deutsche Bank or UBS (I use UBS’s website towards the end of my post.)
MEAN REVERSION
A mean-reverting process is one in which the best prediction of next period’s return is the long run average return plus a correction factor that depends on the deviation of the current return from the long-run average.
If recent returns are above long run average returns, then the correction factor "forces" future returns down. If recent returns are below long run average returns, then the correction factor "forces" future returns up.
If a process is NOT mean reverting, then it may exhibit some sort of trend.
WHY WE INVEST - A LONG TERM VIEW OF ASSET CLASS RETURNS
While hoarding cash under the mattress may look smart today (to both individuals and TARP participants), this is usually not the correct long-term investment strategy.
Below are the 50-year and 25-year real (inflation adjusted) returns for a broad array of asset classes. Note: Longer-term returns are NOT available for all of the listed asset classes.
My table emphasizes several things:
- Current year returns have been almost uniformly rotten;
- Returns over the last 25 years for most asset classes have been exceptional, and well above longer term (such as 50 year) averages;
- Long term US Treasuries have been the best performing asset class over the last 25 years; and
- Investing in residential property has not typically been a reasonable alternative to asset classes (such as stocks or bonds) that provide dividends or coupons.
THE CURSE OF EXCEPTIONAL TIMES: 1980 – 2005
There is no parallel period for investing that approaches the stunning 25 year era that ended in 2005, and which understandably colors our expectations about what we "should" earn on our investments.
In searching for an explanation, the Report suggests that it may reflect demographic influences, which can be simply measured by the relative size of the "asset accumulating" population segment (determined perhaps by proportion of the population between 35 years old and 54 years old).
Ominously, over the last 20 years, Japanese equity returns have been virtually non-existent. Since the worldwide post WWII "Baby Boom" began in Japan in the 1940’s and spread gradually westward, the Japanese demographic hump precedes that of the US by about 15 years.
The Report suggests that demographically-related lousy Japanese equity returns may be echoed, with a lag, by those in the US. If this poor period began here 10 years ago, we may only be halfway through our own rotten times.
Bond returns in the US may be even more closely correlated to demographic bulges than equity returns. The recent 25-year out-performance of long term Treasuries, along with diminished demographic factors, may signal that future real Treasury returns could easily be negative.
The Report suggests that the solution to poor US investment returns and other demographically related problems may lie in either a legislated increase in retirement ages, and/or increased openness to foreign immigration and investment. If these alternatives are not explored, the US future may resemble the Japanese past.
WHERE TO INVEST?
Given possible meager prospects for both real equity and US Treasury returns, what’s left that looks promising?
On a risk-adjusted basis, the Report suggests credit, represented either by investment grade (included in my table, above) or high-yield/lower-rated (excluded from my table, due to lack of 50 year history) corporate bonds, may provide the best returns, since this "asset class … is trading furthest away from its mean and spreads are at levels never before seen in either investment grade or high yield credit."
The Report does not consider mortgages investments, presumably because mortgage securities have been a relatively recent invention. But since prepayment and credit are frequently two sides of the same coin, perhaps this is an opportune time to consider returns derived from assuming prepayment, but no credit, risk.
Where can one get this exposure? Why, in GNMA’s of course.
Below, for what it’s worth, are two relatively long term regression charts, more than thirteen years. Normally, this would be considered a long-term regression, except that the Report is focusing on generations, not years. The first chart shows Actual and Model GN30 spreads to 5 year UST. The second chart simply shows the residuals.
As the charts indicate, while Treasuries may not be compelling, IF you are unwilling (for whatever reason) to invest in the credit sector discussed by the Report, you might want to consider GNMA investments - their yields are very wide to treasuries, although nothing like the credit products discussed in the Report.
Source: UBS Mortgage Strategy Website, www.mtgstrat.com
CONCLUSION
Are there limits to the insight that one can obtain from a mean-reverting analysis? Of course, and pages 29 and 30 of the Report discuss these in more detail and deserve your attention as well.
Given the extraordinary times, from a return perspective, that now plague us, believe there is much to be learned by taking a careful and critical look at where we’ve been. Deutsche Bank’s One Hundred Years of Corporate Bond Returns – Revisited is a good place to start.
Positions: None.
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This article has 11 comments:
Current Treasury rates are "good" only in the sense that we may be facing a financial armageddon. If we muddle through, today's rates may cause investors much distress. GNMA's would be relatively better investments in this case, as spreads would likely narrow.
Japan has a relatively simple mono-genetic culture, with very small additions of Ainu, and Koreans, and essentially no immigration - open or clandestine. As a result, the effects of the baby boom marched through the economy relatively unmediated by immigration, and differences in spending, savings patterns,or ethic variations. Their pattern can be viewed as the worst case scenario.
The United States, with a much more varied ethnic base, and significant in migration, will see less of an effect from the "basic baby boom", in the long term. However, in the short term - for the next two years I estimate, the results will be more severe, for the following reasons:
1. Lower savings rate than Japan means less available liquid resources per individual.
2. Undisciplined lending by banks and other institutions at the urging of government agencies, including the Democratic House.
3. Creation of financial instruments that hid the danger of the cresting demographic wave until too late for action.
Now the really important point to ponder: The Chinese one-child policy has created the artificial equivalent of the baby-boom baby-bust demographic wave IN SPADES. I have yet to overlay the Chinese demographic statistics over the US statistics to determine when the effect of their policy will begin to effect their productivity as severely reduced numbers of young workers enter the work force and older ones head to retirement.
There are so many ethnic, cultural, and economic differences between these three countries that this will be a study that will keep be involved for years.
seekingalpha.com/artic...
and for commodities
seekingalpha.com/artic...
This concept can provide valuable roadmaps for overview of trends and possible trend changes.
The comparison with Japan would benefit from an analysis of currency values. A large part of why Japanese equities sank was deflation. Is the post-baby-boomer US going to experience deflation, with its massive national debt? A large part of why US treasuries were yielding double digits in the early 80's was double-digit inflationary expectations. Outperformance of equities can be traced to periods of historically low inflation.
Excellent article!
The bottom line : US population is growing at 3 million people per year!
en.wikipedia.org/wiki/...