Reading Pessimism in the Market for Bonds

“Certificates of Confiscation.”

Three decades ago, that was what some people said bonds really were. The interest the bond paid would not be enough, they said, to offset the declining value of dollars as inflation added up. The “real” — after-inflation — bond yield would be negative.

That was just as the great bull market in bonds began. Bonds were great investments, and the bond bears turned out to have been dead wrong.

Now we have come full circle. The government is selling bonds that are absolutely, positively guaranteed to not pay enough to offset inflation over the coming years. It is even possible that someone who bought a new Treasury security that will be issued on Monday will end up getting fewer dollars back than he or she invested — interest and principal combined — between now and when the bond matures in 2017.

The securities are inflation-protected Treasury notes. If inflation ticks up significantly over the coming years, investors will get back more dollars than originally invested. But not enough to come close to keeping up with inflation. If there is no inflation, they will get back less than they invested.

When those securities were auctioned last week, buyers agreed to accept a real yield of negative 1.496 percent. It takes a lot of pessimism — about the economy and the future of the United States — to think an investment certain to lose money is an investment worth making.

The great bear market in bonds, both corporates and governments, lasted 35 years, from 1946 to 1981. The bull market lasted about 30 years. A new bear market almost certainly has begun.

If that is true, those seeking a little income now by going out the yield curve will come to rue the decision. They will get the promised interest, but as market interest rates rise, the price of those bonds will decline and decline and decline.

On Oct. 26, 1981, which can be dated as the bottom of the great bond bear market, the yield on 30-year Treasury bonds rose to 15.21 percent. On that date, a Treasury bond issued in 1970 and scheduled to mature in 2000 was quoted at less than 56 percent of face value. It had a coupon of 7.875 percent, but that was not deemed enough to compensate investors for the risk.

At market extremes, it is often worth analyzing what has to be true for a given investment to be a good, or bad, value. Back in 1981, you had to assume that inflation would not only remain in double digits for decades, but that it would also continue to rise, for a newly issued Treasury bond to turn out to be a bad investment. Yet many investors assumed it would be. After all, a lot of people on Wall Street in 1981 could not remember a time when bonds were good investments.

A few weeks before rates peaked, Seth Glickenhaus, an experienced bond trader and head of Glickenhaus & Company, an investment advisory firm, spoke the conventional wisdom when he said, “Anyone who buys a bond today to hold for more than five years is out of his mind.”

Michael Gavin, the head of United States asset allocation for Barclays, pointed out this month that over the past 30 years an investor who stayed invested in American, or British, 10-year government bonds would have earned more than 5 percent a year over inflation.

“It does not require advanced market math to understand that returns like these are no longer remotely plausible,” he wrote. “But they say that fish don’t know that they live in water — until they are removed from it — and we wonder if some of the many market participants whose entire professional experience has been conditioned by the financial backdrop created by the bond market rally might underestimate some consequences of its termination.”

Even if rates stay where they are for the next five years, and investors collect the interest coupons, he said, “bonds will be transformed from wealth creators into wealth destroyers.”

Or at least they will be unless there is severe deflation. For that is the only situation that will allow today’s new long-term bonds to turn into good investments.

Is that possible? To think it is likely, you pretty much have to assume that economic growth is a thing of the past in both the United States and Europe. It is not an optimistic outlook.

James Grant, the editor of Grant’s Interest Rate Observer — and a bear on bonds for some time — argues there are parallels between 1981 and now, at least in conventional wisdom. “Central banks are harmless, said the bond bears in 1981; in a social democracy, inflation is ineradicable,” he writes in the current issue of his publication. “Central bankers are harmless, charge the bond bulls of 2012; in an overleveraged economy, inflation is unachievable.”

One reason bond yields are so low now — at least in markets like Britain and the United States — is the fact that after the Greek fiasco investors have come to fear default more than currency depreciation. That had led to a rush to default-proof bonds, which means bonds issued by countries that can print the currency they borrowed. (It may be that Treasuries will not always be default-proof because a Tea Party-influenced Congress will refuse to allow the government to pay its bills. But so far markets assume the politicians will not be that stupid.)

It is interesting to look at the relationship of stocks and bonds when the bond market is near extremes in valuation. Those moments tend to come when economic uncertainty is high and fears are widespread. In the past, such fears have proved to be wrong.

In 1946, there was a consensus among many economists that a new depression was likely. After all, the 1930s depression did not end until armies put unemployed people to work. Now that the war was over and armies were shrinking, would not the economy retreat again?

Bond prices turned down — and yields up — in the spring of 1946. Stocks sold off that fall, and it was not until 1950 that the stock market got back to where it was when the bond bear market began.

Then stocks enjoyed a phenomenal period. One reason interest rates were rising was that economic growth presented good investment opportunities. The stock market was a very good place to put money throughout the 1950s and into the mid-1960s, occasional recessions and bear markets notwithstanding.

During the last 10 or 15 years of the bond bear market, however, the stock market gyrated but went nowhere. In 1981, as the bond bear market was ending, the Dow Jones industrial average was lower than it had been 15 years earlier. The economy was in recession and optimism was hard to find. There was a consensus that the United States had lost its competitive edge and could not compete with Japan. Share prices did not hit bottom until the summer of 1982.

But in 1982 the golden age of American stock and bond markets began. For nearly two decades, both were usually good places to invest, and the United States economy did well. But the technology stock bubble’s bursting in 2000 signaled an end to an era in the stock market. A share of Fidelity Magellan — one of the most successful mutual funds of the 1980s and 1990s — is now worth less than a share was worth 13 years ago.

As 2012 ends, pessimism is high. Some economists talk of a prolonged period without economic growth in the industrialized world, as the United States and Europe fail to compete with China and India. Investors find a bond guaranteed to lose value — but not to lose all value — to be worth buying.

It is no wonder that major corporations now are issuing long-term bonds even though they don’t appear to have any need for the money. As economic growth picks up in coming years, those companies will appear to have been prescient. The buyers, on the other hand, will seem to have been as foolish as were those who disdained bonds 30 years ago.