By the end of this year, it will have been 20 years in which long dated bonds will have registered superior returns over equities in the US and South Africa. As may be seen in the tables below long dated government bonds have outperformed the equity index in the US and the RSA on both dimensions – they have provided significantly extra annual returns for less risk – as measured by the standard deviation of these returns.
Unexpectedly equities have failed to provide long term investors with a risk premium over long dated bonds. Equities and bonds have returned more than cash over the period though the competition from cash for equities in SA has been very strong over the past 20 years. Encouragingly all asset classes in both economies have provided in returns well ahead of inflation over the past 20 years. Especially so for SA investors (it was not as if equities performed poorly): in real terms they provided excellent average returns of over 5% pa. However, as may be seen, long dated bonds did even better for somewhat less risk.
Annual Returns Equities, bonds and cash calculated monthly 1990-2009
USA
| Sample: 1990:01 2009:09 | ||||
| S&P 500 | US 10 Y TBONDS | US SHORTS | US INFLATION | |
| Mean | 7.2 | 10.6 | 4.1 | 2.8 |
| Median | 11.1 | 12.9 | 4.7 | 2.8 |
| Maximum | 41.6 | 62.1 | 8.3 | 6.3 |
| Minimum | -59.6 | -30.4 | 0.3 | -2.3 |
| Std. Dev. | 18.2 | 15.3 | 2.0 | 1.3 |
| Observations | 237.0 | 237.0 | 237.0 | 237.0 |
RSA
| Sample: 1990:01 2009:09 | ||||
| JSE | SA LONG RSA | CASH | SA INFL | |
| Mean | 13.7 | 16.2 | 12.1 | 8.0 |
| Median | 14.8 | 18.7 | 11.7 | 7.7 |
| Maximum | 54.3 | 41.1 | 21.7 | 16.6 |
| Minimum | -43.4 | -18.8 | 6.8 | 0.1 |
| Std. Dev. | 19.2 | 12.2 | 3.4 | 3.9 |
| Observations | 237.0 | 237.0 | 237.0 | 237.0 |
Source: Investec Private Client Securities
The prices of long dated bonds generally rose over the 20 years as they benefited greatly from low inflation. Long dated interest rates fell back as less inflation was priced into their yields. Clearly the monetary and fiscal authorities consistently surprised the bond market in their ability to reduce inflation – and even more so in the US than in South Africa as we show below. Less inflation expected was good for equity returns and for the real returns from cash – but it turned out to be even better for investors in long dated bonds.
Fixed Interest yields 1990-2009
Source: Investec Private Client Securities
The caveat – past performance is not necessarily a guide to future performance – may be particularly apt when we contemplate expected returns from bonds, equities and cash over the next 20 years. Equities will always be valued to realise an expected premium for the extra risks associated with them. The yield on long dated bonds will always carry a premium to cover expected inflation. But as always, markets may be surprised or disappointed as evidence changes the temporary beliefs captured in current valuations giving rise to unexpectedly good or poor returns.
There is no guarantee that over the next 20 years inflationary expectations will be revised generally downwards as they have been over the past two decades. Given the much deteriorated recent state of government finances in the developed world, the temptation will have risen to print money to finance government expenditure – rather than cut expenditure or raise taxes and or pay market interest rates for funds borrowed. The share of government tax revenues that will have to go to pay interest rather than used for much more popular spending will be rising inexorably over the next few years at least.
Yet the bond markets in the developed world remain highly sanguine about the inflation outlook. The yields on US and other developed country bonds are currently offering inflation compensation of less than two per cent per annum on bonds maturing in 15 or more years, that is nominal bonds issued by Uncle Sam are currently offering near record low yields (about 3.5% pa) and less than two per cent more than the inflation linked bonds that would secure investors a real return over the long run. Currently these long dated inflation linkers also yield less than a two per cent per annum real yield. In SA the bond market is compensating for expected inflation by offering more than six per cent more on vanilla government bonds over their inflation linked equivalents.
We would regard the vanilla government bonds in the US as dangerously exposed to a revival of inflationary expectations. Accordingly holding inflation linked US government bonds seem like the superior alternative for now. By contrast in SA the higher yields on RSA vanilla bonds do now offer more attractive compensation for inflation to come. An average rate of inflation of over 6% per annum now priced into the bond market may well again prove overly pessimistic about the ability of the SA government to contain inflation in the years to come. Perhaps the history of declining bond yields in SA over much of the past twenty years should encourage SA investors to pay more respect to long dated bonds as an asset class.