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30-Year Bond Market Rally

The last time the American T-Bond was traded at current levels was 1946, after the end of World War II. Its return over the next 30 years was negative in real terms: for the next three decades, bond investors lost purchasing power.

US 10-YEAR BOND YIELD (1790 - 2012)

However, events over the last three decades have been completely different. Since 1981 American treasury bonds have increased virtually without interruption and offered a spectacular annual return: 12.6% in the 1980's, 8.8% in the 1990's, 7.7% in the previous decade, and 20% in this decade so far. Accordingly, government bonds during the last 30 years have been considered to be risk-free assets. Similarly, as occurred recently with the real estate sector, investors in government debt securities have been used to holding assets with low volatility which, in addition to paying a coupon, always increase and maintain their price. The current financial crisis has only enhanced the purchase of bonds and since 2008 investors, in the US alone, have invested USD 1.1 billion in funds of this type. At the same time, American shares vehicles have suffered redemptions of 400,000 million. In other words, more than double the amount redeemed in equity funds was virtually invested in fixed-income funds.


With the global AUM of the investment funds above the maximum level of 2007, bond vehicles have recorded maximum subscriptions and AUM in all countries. Similarly, bond exchange-traded funds have also experienced exponential growth, since there are more than 1,300 ETFs that replicate this type of asset, but only 24 are the inverse of this, which offers a clear idea of which side investors have banked on.


It is therefore no wonder that 16 of the fifty largest countries worldwide have traded their sovereign debt at 10 years below 2% or even that over certain periods some countries have traded with negative yields.

After the greatest bull market in the history of bonds, it is necessary to reflect on the risk they currently entail. The bond bubble seems evident. However, prices continue to be easily at record maximums against a backdrop in which everyone assumes that the "flexible" monetary policy will be eternal. However, we must not forget that the primary mandate of the central banks is to control inflation. As soon as any inflation rears its head, the bonds will begin their downturn. If the yield of long-term debt returns to its historical average, the price of 10-year American bonds will depreciate by 26%. In the most extreme case, such as that experienced in the 1980's, the price of the 30-year bond would fall by 80%.

It is difficult to know when and how strong inflation will return. However, there are two significant facts that should not be overlooked: 1) The stabilization of the American real estate market (after adjusting its prices by almost 50%, the greatest since the Great Depression) with the bankruptcy of thousands of real estate agencies and the closing of hundreds of banks; 2) The progressive exchange of balances of China's balance of trade (a country which went gradually from being an exporter to an importer). Both trends could give us hints as to a possible reappearance of inflation.

In inflationary environments, shares behave better than bonds: throughout the last century, with an average inflation of 4.5%, equities offered an annual return of 5.2%, whereas bonds offered almost zero. With inflation of 8.0%, shares have an actual positive return, whereas that of bonds is clearly negative.

Investors' current search for "financial security" caused the return on dividends of the S&P 500 index to be greater than the yield of the 10-year American bond, something that has not taken place since the 1950's, just when the last and largest bear market began for bonds. The same thing happened in Europe, with a spread of 3 points between the dividends of MSCI Europe and the yield of the German bond, the greatest in 90 years.


Similarly, bank deposits in the US have doubled since 2008, which currently represents an increase of 6.6 billion dollars. The enormous amounts of capital accumulated in bonds and deposits are an ideal breeding ground to cause future increases in equities.

Contrary to what one may think, the relationship between shares and bonds is highly erratic (historically fluctuating between +0.6 and -0.4). History is full of periods in which the price of bonds has fallen and that of shares has increased. There is, however, a clear relationship between the turning points of the yield of the debt and the beginnings of "secular" bull equity markets, as can be observed in the graph below, which includes the last century of the American stock market and the yield of the bonds:

S&P 500 vs. US 10-YEAR BOND YIELD (1900 - 2012)

As of today it is impossible to know whether this decade will end up offering excellent returns in equities. However, we do feel that it is highly probable that the return on shares will, in real terms, be clearly above that of bonds not only over the coming years, but over various decades.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.