Bear Essential

Classic Safe Haven Hides in Plain Sight

Despite bonds' paltry returns of late, they're usually reliable when things turn wild.
Photographer: John Sadovy/BIPs/Getty Images

Watch volatility spike, and then watch investors scatter for safety. Only this time, they don’t seem to know where to hide.

After years of calm, market turbulence has returned. The annualized daily standard deviation of the S&P 500 Index -- a common measure of volatility -- has been 18.6 percent from 1928 through March. But the market was much quieter from 2012 through January, with a standard deviation of 12 percent.

That quiet ended abruptly in February. The S&P 500 tumbled 8.5 percent in just five trading days from Feb. 2 to Feb. 8, and its standard deviation has spiked to 23.4 percent since February.

Back to Reality

The recent market calm ended abruptly in February

Sources: Bloomberg, author's calculations

Investors customarily take comfort in bonds when the market teeters, but their faith has been shaken by years of low interest rates not seen since the 1950s and paltry bond returns. The Bloomberg Barclays U.S. Aggregate Bond Index has returned just 2.1 percent annually from 2012 through March.

And investors are rightly even more morose about the future. The correlation between yields on long-term U.S. government bonds and subsequent 10-year annualized returns was a near-perfect 0.92 from 1942 to February 2008, the longest period for which numbers are available. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)

Road Map

Bond yields have been highly correlated with subsequent medium-term returns

Sources: Bloomberg, Federal Reserve, author's calculations

Note: Yield on 20-year U.S. government bonds from 1942 to March 1953, and average yield on 10-, 20- and 30-year U.S. treasuries from April 1953 to March 2018.

In other words, bond yields are good barometers of expected returns over the medium term, with one small caveat: During periods when interest rates are rising, yields tend to overstate future returns, and vice versa.

The last eight decades are instructive. From the 1940s to the early 1980s, yields on long-term government bonds rose from roughly 2 percent to upwards of 15 percent. Rising yields were a drag on returns because bond yields and prices move in opposite directions. The average yield was 4.8 percent from 1942 to a peak in September 1981, but the average subsequent 10-year return was 4 percent a year.

It was just the opposite over the last four decades. The yield on long-term government bonds has fallen to roughly 3 percent since September 1981. This time, falling yields boosted returns. The average yield was 7.3 percent from October 1981 to February 2008, while the average subsequent 10-year return was 9.2 percent a year.

It’s a mistake, however, to assume that bonds’ muted outlook will hamper their ability to hold up during market downturns.

In fact, during the 20 bear markets since 1928 -- as measured by a decline of 20 percent or more in the S&P 500 -- the average return from long-term government bonds was 5 percent, and the median return was 3.2 percent.

Safe Haven

Bonds have been a reliable store of value during bear markets

Sources: Bloomberg, S&P, author's calculations

Importantly, bonds managed to hold their ground during the seven bear markets between 1946 and 1974 when yields were low or rising. The average return was a negative 1.5 percent, and the median was a negative 0.3 percent. That compares with an average cumulative total return for the S&P 500 of negative 20.7 percent and a median of negative 21.8 percent.

The one notable exception over those 20 bear markets was that bonds returned a negative 14.6 percent from December 1968 to June 1970, compared with a negative 29.2 percent for the S&P 500.

Investors should consider that history when looking for shelter, as well as that of other perceived safe havens. In 1968, members of the so-called London gold pool, including the U.S., agreed to allow the private market price of gold to fluctuate. There have been six bear markets since then. Prices rose during four of those bear markets, but gold disappointed during the other two, falling 11 percent from December 1968 to June 1970 and 44.7 percent from December 1980 to July 1982.

Gold’s penchant for drastic declines is reminiscent of another currency that some think is a reliable store of value. Bitcoin’s price history stretches back only to July 2010, and there haven’t been any bear markets since. But there have been four corrections -- as defined by a decline of 10 percent or more in the S&P 500 -- and Bitcoin has been shaky. The cryptocurrency declined in three of four of those corrections, most recently by 24.9 percent from Jan. 29 to Feb. 8.

None of this means investors should dump their stocks -- all-in-all-out market timing moves are doomed to fail. But there’s a good reason 40 percent of the classic 60/40 portfolio is reserved for bonds. And there’s no better time to be reminded.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Nir Kaissar in New York at nkaissar1@bloomberg.net

    To contact the editor responsible for this story:
    Daniel Niemi at dniemi1@bloomberg.net

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