Thursday, May 5, 2022

The Rout in Long-Term Bonds

The total return on Vanguard’s Canadian Long-Term Bond Index ETF (VLB) since 2020 October 27 is a painful loss of 24%.  Why did I choose that particular date to report this loss?  That’s when I wrote the article Owning Today’s Long-Term Bonds is Crazy.

Did I know that the Canadian Long-Term bonds returns would be this bad over the past 18 months?

No, I didn’t.  But I did know that returns were likely to be poor over the full duration of the bonds.  Either interest rates were going to rise and long-term bonds would be clobbered (as they have been), or interest rates were going to stay low and give rock-bottom yields for many years.  Either way, starting from a year and a half ago, long-term bond returns were destined to be poor.

Does this mean we should all pile into stocks?

No.  If you own bonds to blunt the volatility of stocks, you can choose short-term bonds or even high-interest savings accounts.  This is what I did back when interest rates became low.

Does that mean everyone should get out of long-term bonds?

It’s too late to avoid the pain long-term bondholders have already experienced.  I’m still choosing to avoid long-term bonds in case interest rates rise more, but the yield to maturity is now high enough that owning long-term bonds isn’t crazy.

Isn’t switching back and forth between long and short bonds just a form of active management?

Perhaps.  But it’s important to understand that bonds and stocks are very different.  Stock returns are wild and impossible to predict accurately.  There is no evidence that anyone can reliably time the stock market.  However, when you hold a (government) bond to maturity, you know exactly what you will get (in nominal terms).  When a long-term bond offers a yield well below any reasonable guess of future inflation, buying it is just locking in a near-certain loss of buying power for a long time.

Are investors safe if they own a bond fund with a mix of maturities?

Bond funds with a mix of maturities certainly mask what is going on, but that doesn’t save investors.  Eighteen months ago, the long term bond portion of aggregate bond funds were destined to perform terribly.  It was predictable that short-term bond funds would perform better than aggregate bond funds.  The fact that all this was largely invisible to bond fund holders didn’t change the fact that the long-term bonds in their aggregate bond funds got hammered.  Over 18 months, Vanguard’s aggregate bond ETF lost 13%, while the short-term bond ETF lost only 5%.

Will it ever make sense to own long-term bonds?

If Real-Return Bonds (RRBs) ever offer high enough returns above inflation again, I would certainly consider buying some.  The idea of getting a non-trivial return along with inflation protection is very appealing.


It pays to think about what you’re owning when it comes to bonds.  You can’t learn anything useful by just staring at the price movements of your bond ETFs.  Long-term bonds become dangerous after their prices rise to the point where yields looking forward become very small.


  1. So indexing isn't something that can be done mechanically?

    Does valuation of the index components matter? How is the layman investor is supposed to make sense of it?

    Are stocks overvalued as well?

    Is it always prudent to have some cash in the portfolio or should the investor always be fully invested?

    1. Indexing certainly is something that can be done mechanically. I index my stocks, but not my fixed income. Others are free to do as they wish.

      Trying to value most assets other than government bonds is futile. The layman investor can choose not to try to make sense of any of this and just lose money in long-term bonds in the conditions that existed 18 months ago. None of this changes the fact that the rout in long-term bonds was predictable, in contrast to the returns in stocks and real estate that are not predictable with any reasonable degree of accuracy.

      It doesn't matter if stocks are overvalued. What matters is what they'll do in the future, and we don't know this. In contrast, long-term bonds from 18 months ago were certain to pay almost nothing for the rest of their duration.

      It's important to have available cash to live on as a buffer (such as an emergency fund). However, having cash available to jump on investment opportunities is a waste for almost all people.

    2. I have the possibly heretical notion that there is a limited ability to time the stock market went it uncommonly reaches extremes of valuation. I've never thought much about timing the bond market. But you point out that bond returns - based on yield to maturity - are highly predictable for government bonds. I've also seen good data for investment grade bonds. Market timing such bonds implies an ability to predict interest rates. My belief about stock market timing is based on a belief in reversion to the mean. Based on the greater predictability of the bond market, then I should have a stronger belief in reversion to the mean at extremes of interest rates. IIRC, Warren Buffett has occasionally invested in bonds, when he finds them attractive. Of course, I'm not Warren Buffett :-).

    3. Cash sounds good in theory. But in practice, it can be emotionally painful. The real return of cash in the last year may not make me cry, but I've come close. How much cash should a person have? That's a very personal question. I've reached the stage in my life, where case as a portion of my portfolio can be very small. I still keep about a month's worth of expenses in cash. Why? That's in case the stock market closes for a month. I can't sell stocks to raise cash, if the market is closed. One can make a case for more than 1 month. Can I assume that dividends will be there? Of course, during a bear market, they will go down. But what if dividends are suspended? The risk may be extremely small, but I think it exists. In 2020, British bank dividends were suspended. There will likely be crises greater than 2020 in the future. And in the Canadian stock markets, Canadian bank dividends make up a good portion of stock market dividends. What about margin lending? If the stock market is closed, I'm not certain that borrowing against your stocks will be possible. And even with a open market, margin loans are demand loans. About market closure, dividend suspension and margin loan suspension, they are most likely going to happen when you least want them too. Of course, someone might (correctly?) say that I'm being paranoid. Nevertheless, diversification of sources of possible liquidity makes sense. And the cost of insuring for a short term doomsday scenario may be worth it. As you can't insure against a long term doomsday scenario, it makes sense to keep the insurance short term. That begs the question, as to what is short term? Three months?

    4. I'm the author of the last comment, and it's in the wrong place. It was intended as a response to your post regarding Morgan Housel.

    5. To the first anonymous commenter: Stocks show more than the typical amount of mean reversion, but even when prices rise to dizzying heights, it's impossible to know whether any other asset class will be better than stocks. One way for stocks to mean revert is for prices to lag earnings growth 1% a year for a couple of decades. In such a scenario, stocks might still outperform everything else.

  2. To the second anonymous commenter: I copied your comment to the relevant post and replied to it there.