Many retail investors shun the bond market because it can be difficult to understand and it doesn't offer the same level of potential upside as the stock market. While the bond market is different from the stock market, it can't be ignored. Its size (comparable to the stock market) and depth will ensure this never happens. With the help of the book "Triumph Of The Optimists: 101 Years Of Global Investment Returns" (2002), by Elroy Dimson, Paul Marsh and Mike Staunton, we will look at how the global bond market performed over the twentieth century and what changes we foresee for it during the twenty-first. (For a look at the stock market during the same period, see The Stock Market: A Look Back.)

An Unkind Century for Bond Investors
Equity investors triumphed over bond investors during the twentieth century because the risk premium built into bonds during the 1900s was much too low to compensate investors for the forthcoming turmoil that would hit the bond market over the next century. This period saw two secular bear and bull markets in U.S. fixed income, with inflation peaking at the end of the First and Second World Wars as a result of increased government spending during those periods.

The first bull market started after World War I and lasted until after World War II. According to Dimson, Marsh and Staunton, the U.S. government kept bond yields artificially low through the inflationary period of World War II and up to 1951. It wasn't until these restrictions were lifted that the bond market began to reflect the new inflationary environment. For example, from a low of 1.9% in 1951, long-term U.S. bond yields then climbed to a high of nearly 15% by 1981. This was the turning point for the century's second bull market.

The graph below shows real government bond returns for the twentieth century. Ironically, while all the countries listed in the table below showed positive real returns on their equity markets during this period, the same could not be said about their bond markets.


The countries that did show negative real returns were those most affected by the world wars. For example, Germany saw two periods in which fixed income was all but wiped out. During the worst of the two periods, 1922-23, inflation reached an unfathomable 209,000,000,000%! According to "Triumph Of The Optimists", 300 paper mills and 150 printing works with 2,000 presses worked day and night to accommodate the demand for bank notes during this period! In fact, the twentieth century had more than one incidence of hyperinflation, but none was as severe as what Germany saw in the early 1920s. (For more insight, see the Inflation tutorial.)

The graph below contrasts real government bond returns for the first and second half of the twentieth century. Notice how the countries that saw their bond markets do very poorly in the first half of the twentieth century saw a reversal in their fate in the second half:


While this illustration gives you a good feel for the government bond market, the U.S. corporate bond market, according to Dimson, Marsh and Staunton, fared better as well, and added an average 100 basis points above comparable government bonds over the twentieth century. They calculated that roughly half of this difference was related to the default premium (the premium rewarded for taking on default risk). The other half is related to defaults, downgrades and early calls. (To learn more, see Corporate Bonds: An Introduction To Credit Risk.)

The Bond Market Would Never Be the Same
In the 1970s, the globalization of the world markets began again in earnest. Not since the Gilded Age (1876-1914) had the world seen such globalization, and this would really start to have an impact on the bond markets in the 1980s. Until then, retail investors, mutual funds and foreign investors were not a big part of the bond market. According to Daniel Fuss' 2001 article "Fixed Income Management: Past, Present And Future", the bond market would see more development and innovation in the last two decades of the twentieth century than it had in the previous two centuries. For example, new asset classes such as inflation-protected securities, asset-backed securities (ABS), mortgage-backed securities, high-yield securities and catastrophe bonds were created. Early investors in these new securities were compensated for taking on the challenge of understanding and pricing them.

Innovation in the Twenty-First Century
Entering the twenty-first century, the bond market was coming off its greatest bull market. Long-term bond yields had compressed from a high of nearly 15% in 1981 to 7% by the end of the century, leading to higher bond prices. Innovation in the bond market also increased during the last three decades of the twentieth century, and this will likely continue. Furthermore, securitization may be unstoppable, and anything and everything with future material cash flows is open to being turned into an ABS. Health care receivables, mutual fund fees and student loans, for example, are just a few of the areas being developed for the ABS marketplace.

Another likely development is that derivatives will become a bigger part of institutional fixed income, with the use of such instruments as interest-rate futures, interest-rate swaps and credit default swaps. Based on issuance and liquidity, the U.S. and the Eurobond markets will maintain their dominance of the global bond market. As bond market liquidity improves, bond exchange-traded funds (ETFs) will keep on gaining market share. ETFs have the ability to demystify fixed-income investing for the retail client through their tradability and transparency (for example, Barclays iShares website contains daily data on its bond ETFs). Finally, continued strong demand for fixed income by the likes of pension funds will only help accelerate these trends over the next few decades. (For more information, read Bond ETFs: A Viable Alternative.)

Conclusion
For the most part, investing in fixed income during the past century was not an overly lucrative proposition. As a result, today's fixed-income investor should demand a higher risk premium. If this occurs, it will have important implications for asset allocation decisions. Increased demand for fixed income will only help to further innovation, which has turned this asset class from stodgy to fashionable.

For further reading, check out Advanced Bond Concepts.

by Investopedia.com , (Contact Author | Biography)