If today’s bond market seems complicated, take a few moments to read a short history of the bond market to gain perspective. Some investors avoid the bond market because it doesn’t provide significant upside potential. In recent years, interest rates have declined to historical low levels. Several decades ago, bond yields were more generous and the idea of investing money at a guaranteed rate of return over a certain period of time was considered a sound conservative investment strategy:
- For instance, investing your money in tax-free bonds paying 12 percent a year in 1980 yielded a double of your money in just six years.
- Comparatively, if you invest money in bonds at 2 percent, your money will double in more in 35 years.
From the 1990s decade through 2005, Bank of New York research says the average 10-year bond yielded about 7 percent. After a period of high inflation in the 1970s, investors enjoyed double-digit bond yields in the 1980s. That said, the bond market isn’t comparable to the stock market. It’s a much bigger, deeper market, and naturally limits investors’ returns.
A Short History of the Bond Market
Stock investors earned more money than bond holders in the 20th century because stocks were considered a higher-risk asset. During the century, stock investors survived two deep bear markets and several extraordinary bull markets.
Bond prices rose from average six to seven percent levels in the 1970s to stunning rates as Ronald Reagan assumed the presidency. Inflation peaked after both world wars and again as the 1970s decade came to a close as government spent higher than usual amounts of money.
There were bond bull markets in the 20th century:
- The first began at the end of World War I and continued through the World War II years. In post-WW II America, the government kept bond yields low from 1944 to 1951.
- At that point, U.S. bond returns rose from less than 2 percent (1951) to about 15 percent (1981).
Earning a 15 percent in Treasury bonds seems like a dream-come-true today but, at the time bond yields were high, many of America’s blue chip companies face significant financial troubles. Worries about continued inflation caused some investors to bet on rising prices of gold or diamonds as the DJIA broke 1,000 for the first time.
Corporate bonds were also popular in the 1980s decade. According to The Wall Street Journal, top credit corporate issuers paid an average of one percent more than Treasury paper. The default premium on bonds was considered higher in the day, too.
Before the 1980s decade, most high-rated corporate and municipal bonds were considered safe, low-risk investments. Bond issuers typically paid their bills on time:
- Corporate issuers like Long Island Lighting defaulted on debt and safety-minded investors lost huge sums in bonds and preferred issues. At the same time, less risk-averse bought distressed bonds and preferred shares at a discount with the prospect of earning higher returns when the issuer offered a negotiated repayment plan.
- Other sectors of the “safe” bond market were also affected. Municipal bond issuers like the Washington Public Power Supply System (WPPSS) defaulted on more than USD 2 billion of supposedly high-credit municipal paper. By 1988, bondholders received a USD 753 settlement but the receipt of 10 to 40 cents on the dollar was little consolation. Investors referred to the massive default as “Whoops” because cost-overruns and unprecedented setbacks were encountered by the project.
According to “A Modern Approach to Graham and Dodd Investing,” (2004) investors like Warren Buffett profited from the purchase of distressed bonds. Buffett reportedly purchased WPPSS bonds at a 16 percent tax-free return to maturity. However, at the time Buffett bought the bonds, repayment was hardly a certainty!
Bonds Markets Globalization
As the 1980s decade began, U.S. investors searched for higher stock and bond returns in the international markets. Mutual fund companies created stock and bond portfolios in these foreign markets as a result.
However, the true globalization of debt markets didn’t really develop in earnest until the 1990s. Author Daniel Fuss (Fixed Income Management: Past, Present & Future, 2001) wrote that the international bond market developed more in the last 10 to 20 years of the 20th century than it had for 200 years before. Investors now had the choice to buy inflation-hedged or protected securities (IPS), high yield bonds, asset-backed securities (ABS), and mortgage-backed securities (MBS). Higher coupon catastrophe bonds (CAT bonds) were also developed to raise money for insurers covering tornado, earthquake, or hurricane zones.
History shows that some of these new assets faced problems in the real world. Mortgage problems of real estate holders affected MBS owners. Real people sometimes defaulted on credit cards or auto loans backing asset-backed securities.
By the start of the 21st century, investors earned an average 7 percent return on fixed income investments. Bond prices rose on other, earlier bonds to reflect the lower interest rate environment.
Bond Markets Today
Securitization of bonds was a new concept in the 20th century but it’s widely accepted today. Fixed income assets are securitized by a wide range of cash flow-generating assets, including health care and medical receivables, student loans, or financial products fees (such as mutual funds used in retirement plans).
Derivatives, including plain vanilla options and exotic structured financial products, also play an important role in the current bond market. According to the Bank for International Settlements (BIS), the notional amount of fixed income-related derivatives instruments is many times the total underlying volume. Institutional fixed income departments use derivatives to hedge against higher or lower interest rates, so interest rate swaps, futures, and credit default swaps are commonplace in the bond market now.
Exchange traded funds (ETFs) also continue to gain market share because retail investors like them. Buying a bond ETF makes it easier for investors to benefit from an underlying portfolio of bonds without the need to understand how to trade bonds in the bond market. Bond ETFs trade like shares of stock. Large investor pools, such as pension funds, acquire large positions in bond ETFs as well.
Bond Market Future
The evolution of the bond market shows that owning bonds involves risk. Fixed income analysis and equity analysis are no longer worlds apart. Some bonds, such as high yield bonds and junk bonds, are evaluated more like stocks as a result.
This brief history of the bond market shows that fixed income cycles can be long and timing the bond market can be difficult. It’s clear that investors want higher risk premiums to own bonds now as the yield curve starts to rise once more. There’s no clear indication of when bond coupon rates will rise again, but it’s relatively certain that issuers will pay more for their debt in the future.