GMO first quarter 2015 letter titled, “Breaking Out Of Bondage” by Ben Inker

The past year has witnessed yet another rally in long-term bonds all around the world. This move has driven long-term bond yields to extremely low levels, in many cases completely unprecedented. The reasons are not particularly mysterious. A combination of low inflation associated with the collapse in commodity prices and quantitative easing has pushed yields ever lower, particularly in Europe, where the list of countries hitting all-time lows in bond yields has hit double digits. Switzerland, whose bond market is admittedly of more academic than market importance, has claimed the distinction of being the first country in history to have its 10-year bond yield turn negative. At current yields, the utility of long-term government bonds in most investment portfolios is questionable at best. To our minds, any investors who are not required to own longterm government bonds in their portfolios should warmly consider getting rid of them, and those tempted to speculate on the future pricing of bonds may want to consider the benefits of betting that European and perhaps Japanese bond yields will be higher in the future. The obvious question this recommendation leads to is what to do with the money that isn’t being put in long duration bonds. We don’t believe that investors should use it as an excuse to buy more equities, but do believe that investors should consider both shortening up the duration of their bond portfolios – the low yields on cash today are a decent trade-off against the possibility of significant losses on bonds in the future – and expanding holdings of alternative investments, such as conservative hedge funds, as well. This makes sense for U.S.-based investors, but is even more essential for investors in Europe and Japan.

GMO: It’s been a very good ride

Over the past 30 years, the MSCI World equity index has returned 7.5% above inflation. Readers of GMO Quarterly Letters over the years are probably used to our arguments that the next 30 years are unlikely to be as friendly to equity investors. But this Quarterly will not be making that argument. This is not because we have changed our minds with regards to equities, but because today the equity markets seem to be less oddly priced than the other major asset that most investors have had in their portfolios over the last three decades: government bonds.

Over the same 30-year period that global stocks have delivered their stellar +7.5% real return, a constant maturity portfolio of 30-year U.S. Treasuries has delivered a no less impressive +6.2% real. This has left investors in the happy situation of having pretty much no bad answer to the asset allocation question: stocks or bonds? And lest you think that my cherry-picking the 30-year bond is the key to this point, the Barclay’s U.S. Aggregate Bond index delivered an even higher +6.6% real, and a buy and hold investor in the 30-year Treasury issued in the spring of 1985 would have achieved almost +9.0% real!

As an asset allocator by profession, there is something rather sobering to the thought that over the last 30 years, any asset allocation at all would have led to pretty much the same (very good) return. But that thought is a triple shot of tequila relative to the thought of what the next 30 years are going to bring to bond investors. For while it is unlikely that stock investors are going to achieve anything like as strong a return over the next 30 years as they did over the last, it is basically impossible for bond investors to duplicate their feat.1 In March of 1985, the U.S. 30-year Treasury Bond yielded 11.57%. In March 2015, it yielded 2.56%. Exhibit 1 shows 30-year bond yields over the past decade across six developed countries.

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A buy and hold investor in a U.S. 30-year Treasury Bond can be pretty sure what he is going to get between now and 2045: 2.56%. And 2.56% is about as good as a long-term bond gets these days. The U.K. 30-year Gilt yields 2.31%, the 30-year Canadian Government Bond yields 1.98%, the 30-year Japanese Government Bond yields 1.34%, the 30-year German Bund yields 0.58%, and the Swiss 30-year yields 0.43%. For an investor choosing among the 30-year government bonds available today, I have a lot of sympathy for anyone who chooses that 2.56% yielding U.S. Treasury. Given long-term expected inflation in the U.S. of around 2.1%,2 at least the prospective real yield is positive. The same cannot be said of any of the other markets mentioned, because expected inflation is higher than the 30-year bond yield in each one.

GMO: Rational investment reasons to hold long-term bonds?

Holding aside regulatory requirements and greater-fool speculation, why would an investor sign up to lose money after inflation over a 30-year period? Two possibilities come to mind. The first possibility would be if the asset in question was such a wonderful hedge against bad economic events that it allowed the investor to hold enough additional risky assets to make up for the losses on the loss-making asset. The second possibility is even simpler: that plausible alternative investments are even worse. Let’s take the second possibility first. At first blush, this idea seems to have a fair bit of merit today. If the alternative investment to holding a 30-year bond is holding a shorter-term bond, shorter-term bonds do indeed look “worse” in all of the markets mentioned. Cash rates and shorter-term bond rates are lower than the 30-year rate in each market. Historically, 30-year bonds have tended to offer a yield premium of at least 1.5% over cash rates in most markets; in the U.S., the average has been 2.4% over the last 30 years. If we imagine that investors demand 1.5% more from a 30-year bond today than they do from cash, we can calculate what investors would have to think cash rates will average over the next 30 years in order for the 30-year bond to be “fair.” Exhibit 2 shows those rates in absolute terms, and Exhibit 3 shows them in inflation-adjusted terms.

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See full PDF below.