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Bond returns and volatility

By David Luhman on Sun, 06/28/2009 - 16:07

Bond returns and volatility

Real long-term returns on bonds

For most of the past 70 years, long-term government bonds have yielded about 2 percent more than inflation. Now, investors are demanding almost 4 percent more than inflation.

The bond market also reacts quickly to news about potential inflation. At one time it was safe for widows and orphans to invest in long-term bonds because interest rates were stable and inflation was moderate.

Bond market is very volatile now

Now however, the bond market is volatile. If the economy begins to grow at a high rate, this may translate into inflation which will destroy bond values. So if news comes out about excessive job growth, bond traders take this as good news for the economy but bad news for the bond market.

In fact the bond market perversely loves bad economic news. If the economy is weak, inflation will be low, and bond prices will increase. In fact, the Great Depression of the 1930s was a terrible time for stocks, but a fantastic time for bonds.

In the early 1930s bond prices doubled while stock prices fell by almost 90 percent.

So the bond market reacts violently to news about the economy and the government's willingness to control inflation. It's not uncommon to see long-term bond prices move by 2 or even 3 percent in one day.

Bond volatility vs. stock volatility

This kind of move rarely makes headlines, but I can guarantee that if the stock market lost 3 percent of its value in one day, there would be headlines about it. Because the bond market has become nearly as volatile as the stock market, returns from the bond market may be close to returns from the stock market for the foreseeable future.

This is because investors want the maximum return for the lowest risk. If bonds have become riskier, and they have, the returns from bonds also should increase.

So although nowadays everyone seems to be saying that stocks are the only place to be, bonds might be a good place to be for the last half of the 1990s. But keep your eyes out for inflation and the government's level of debt.

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