Death by Bonds II

Here I go again. Bond bashing time. I think many income investors worried about risk mistakenly focus too much on the lower volatility of bonds as a risk measure. Volatility is only one measure of risk. On other measures of risk bonds perform just as poorly as stocks but with lower returns than stocks. Lets look at some of these other measures of risk and what they tell us about bonds.

One of my favorite measures of risk is drawdown, i.e. the maximum peak to trough loss for an investment. It is a measure of the first rule in risk management, don’t lose money, and the second rule, remember rule one. You can only worry about volatility if your are relatively assured of capital preservation. I posted on the drawdowns of stocks and bonds in this post and showed that historically stocks have much higher drawdowns than bonds. I said the the bond bubble talk was over hyped and that even rising rates may not be that bad for bonds. I then finished the post with this comment, ‘For me, the real risk of bonds is not providing adequate returns to keep up with inflation and taxes over long periods of time, a risk that is rarely talked about.‘  I’m always careful not to stick too firmly to long held investment axioms and am always trying to learn and improve my investment process. So, when I ran across the following chart in the Credit Suisse Global Investment Yearbook I did a double take.

This chart measure drawdowns in real terms versus the nominal terms that were used in the data I published in that previous post. Taken together the data shows that while in nominal terms bond drawdowns are much lower than stocks, in real terms bond drawdowns are just as bad. In the end, as they say, we all eat real returns not nominal returns so this distinction is absolutely critical. The real data also shows just how devastating inflation is to bonds. Bond drawdowns hit their peak in the inflationary 1970s. In short this data says that in inflation adjusted terms bonds are just as risky as stocks!

Also, as I discussed in detail in my first Death By Bonds post, bonds don’t make a difference to safe withdrawal rates in retirement and they are often used in the wrong way in retirement portfolios. Cash is a better and safer way to lower risk and provide diversification in retirement portfolios. This is particularly true in such a low interest rate environment where the opportunity cost of cash is not very high.

In summary, using drawdown as a measure of risk in real terms bonds look to be just as risky as stocks and are not the diversification panacea they are made out to be in traditional asset allocation. While there are always times when bonds will be cheap vs stocks and vice versa, investors and in particular retirees should always keenly aware the impact of inflation on bond returns.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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