The Independent Market Observer

What the Bond Market Is Telling Us

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 16, 2016 3:15:29 PM

and tagged Investing

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bond marketYesterday, we talked about what the stock market is really saying. Briefly, despite all of the bad news out there, the stock market has not collapsed and the world is not coming to an end, at least in the short term. This, of course, is good news—but an absence of catastrophe doesn’t mean things will be good, either.

This is where the bond market can provide useful, although not cheerful, information.

Growth could continue to be slow. Although the hope for faster growth both here in the U.S. and around the world continues, the bond market is expecting more of the same slow growth we’ve seen over the past several years. No disaster, to be sure, but neither any acceleration. What we have now is probably as good as it gets for quite a while.

Large areas of the globe are worrisome. The reason U.S., German, and Japanese yields, among others, are so low is that investors are moving money away from assets that are perceived as less safe, which covers a large part of the world. The bond market is telling us that the real risks outside the most stable countries are rising substantially, and that investors would rather lock in a small loss than take a chance on a much larger one. This is a scary take for the riskier areas.

Investment returns may well be lower over the next 10 years. This is both a message and a consequence. It arises from the slower growth expected, which will depress both earnings growth and valuations over time, and from direct effects on returns. After all, the return from a bond portfolio held to maturity is just the interest less any defaults, so low interest rates mean lower bond returns. If you model stocks as a bond return plus a risk premium, lower bond yields also mean lower returns over time unless the risk premium increases, and there are no signs of that.

In short, investors don’t seem likely to make the kind of money they have in the past (and probably not what they expect).

Heeding both markets’ messages

While the stock market is telling us not to panic, at least in the short term, the bond market suggests that things aren’t likely to get much better, either, and that the real risks to investors are over the longer term. 

From an investment standpoint, let's look at this using my usual “failure risk” approach:

  • Fast failure (i.e., a crash) does not seem very likely right now, although the risk levels remain high.
  • Slow failure (i.e., the risk that returns will underperform against expectations and targets) seems to be the more immediate problem. With probable returns well below historical levels (and, in many cases, expectations), the chances of slow failure are rising.

Basically, this is the message the bond market is sending us: Be sure that your expectations are in line with slow growth and lower returns. If the stock market is saying there’s no short-term disaster in view, the bond market is hinting that a disaster over the longer term might be.

As investors, we should be paying attention to both.

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