Interest rate cycles are long
I put up the chart of the 10-year bond yield (above) to give the reader a sense of historical perspective with respect to interest rates. Bond market cycles are extremely long. Over the past century (roughly) we have had three cycles: A bond bull market from 1920 to 1946, where the 10-year bond yield declined from 6% to 2%. We then had a bond bear market from 1946 to 1981, where rates jumped from 2% to 16%, and then a secular bond bull market starting in 1981 and ending (probably) early this year. The latest bond bull market began as Paul Volcker tightened aggressively in the early 1980s in order to kill inflation and ended as the Fed drove rates as low as they could through quantitative easing.
Since May 1st, the bond market in the U.S. has sold off as expectations of global growth increase. Japan is conducting its own version of asset purchases (quantitative easing) and fears that Europe will suffer a major sovereign debt crisis have receded. If this is the beginning of a secular bear market in bonds, it could well last into mid-century.
Yes, Virginia, you can lose money in “risk free” bonds
Over the past 30 years, bonds, particularly Treasuries, have had a stellar reputation as THE port in a storm and have performed well, giving investors both cash flows and capital gains. Treasuries are called “risk free” because the government will always pay you your principal and interest. If you hold the bond to maturity, you will get your principal back and all of the interest the government owes you. However, this is a simplistic way to look at it. They didn’t always have that stellar reputation – in the late 1970s, Treasuries were derisively called “certificates of confiscation.” If there is one environment where Treasuries absolutely under-perform, it is during inflationary economies. Even if we don’t have a return of 1970s style inflation, Treasuries can still lose money.
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