At the battle of Balaclava in 1854, the Light Brigade of the British cavalry, led by Lord Cardigan, charged Russian cannons, with a predictably tragic outcome. Investors who are now buying up government bonds are, in all likelihood, riding toward a massacre of similar proportions. With U.S. 10-year government bond yields recently achieving historic lows, this poses a difficult asset allocation problem for investors: What is one to do for bonds in this yield-impoverished environment?
The lessons of history
I began this article with a historical metaphor, and I'm going to present a warning from the history books against the bloodletting investors are setting themselves up for. At that end of last month, on May 29, the U.S. 10-year Treasury yield fell to 1.65%, the lowest value since March 1946. How, then, did bond investors fare the last time yields were at this level? The following table shows the after-inflation annualized return long-term government bonds produced over the five-, 10-, 20- and 30-year periods beginning in April 1946:
Real Return on U.S. Long-Term Government Bonds, Starting in April 1946
Source: Ibbotson Associates, a division of Morningstar; author's calculations.
These numbers are absolutely horrific. Let me remind you that these returns are annualized: Over the 10-year period spanning April 1946 through March 1956, for example, the purchasing power of one's investment suffered nearly a one-fourth decline. There is little reason to believe that long-term government bonds bought today will produce a significantly different result.
It could be even worse
This experience was not isolated in time or geography, as the following table of gilt (U.K. government bonds) returns demonstrates. In fact, U.K. investors who bought gilts at the end of 1946 were left even worse off than their U.S. counterparts, as the following table shows. I've also included returns starting at the turn of the 20th century, another point at which U.K. government bond yields were very low (though at 2.74% in December 1899, they were still quite a bit higher than they are today).
Source: Barclays Equity Gilt Study 2011.
Perhaps you think these examples are just the product of data mining, that I have pulled three historical examples favorable to my argument and ignored the others. That might be a valid objection if there were no fundamental underpinning to the phenomenon I've described. There is: Bond yields -- and, therefore, bond returns -- are mean-reverting. In plain English, this means that periods of below-average yields tend to usher in periods of above-average yields. As yields ultimately rise off current lows, bond prices will fall, depressing total returns.
For investors with an adequate timeframe who are looking for relatively low-risk income investments, I think the Vanguard Dividend Appreciation ETF (NYS: VIG) is a possibility, but it's not a satisfactory response to the asset allocation problem: What is one to do for one's fixed income allocation? These are my thoughts and suggestions.
Ban these funds (from your portfolio)!
To begin with, when an asset class is overvalued, it follows that one should be underweight that asset class to the benefit of cash or undervalued asset classes. Products like the iShares Barclays 20+ Year Treasury Bond ETF, the Vanguard Extended Duration Treasury Index (NYS: EDV) or the Vanguard Long-Term Government Bond Index (NYS: VGLT) should be banned from your portfolio. If you feel compelled own bonds with essentially no credit risk, then I would suggest the iShares Barclays MBS Bond Fund (NYS: MBB) or the Vanguard Mortgage-Backed Securities Index ETF instead.
Remember, however, that there is -- by definition -- little advantage to be gained in owning assets that offer little or no value for the sake of filling a "bucket" in your portfolio. There is nothing wrong in carrying an overweight position in cash until you find more satisfactory options for your investment assets.
Don't bet against them, either
Finally, if there is one thing that I strongly urge individual (or professional) investors not to do, it is to bet against government bonds using a product like the UltraShort 20+Year Treasury (NYS: TBT) . That might sound curious coming from someone who has spent the better part of this article arguing that the bonds are overvalued. Nevertheless, we are entering a period in which there is an increasing global scarcity of "risk-free" assets; as such, while government bond yields will ultimately rise, I see no obvious catalyst for increases in the near future. There is absolutely no reason bond yields cannot stay at current levels for the next six months, the next year, the next two years or even longer.
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At the time thisarticle was published Fool contributorAlex Dumortierholds no position in any company mentioned. Clickhereto see his holdings and a short bio; you can follow him onLinkedIn. Motley Foolnewsletter serviceshave recommended writing puts on ProShares UltraShort Lehman 20. The Motley Fool has adisclosure policy.We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolishnewsletter servicesfree for 30 days.
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