n short, bondholders in the twentieth century were blindsided by what financial economists call a "thousand year flood": in this case the disappearance of constant-value gold-backed money. Before the twentieth century, nations had temporarily gone off the hard money standard, usually during wartime, but its permanent global abandonment was never contemplated until a decade before it finally occurred after World War I.
The shift in the investment landscape was cataclysmic, and the resulting financial damage done to bonds was of the sort previously seen only as the result of revolution and military disaster. Even in the United States, which suffered no challenge to its government or territory in the 1900s, bond losses were severe.
Consider that in 1925, the U.S. stockholder and bondholder both received a 5% yield. The bondholder could reasonably expect that this 5% yield was a real one—that is, that its fixed value would not decrease over time. The stockholder, on the other hand, balanced the prospect of modest dividend growth versus the much higher risk of stocks. The abandonment of hard money turned all that upside down—suddenly, the future value of the bondholder’s income stream was radically devalued by higher inflation, whereas that of the stockholder was enhanced by the ability of corporations to increase their earnings and dividends with inflation. It took investors more than a generation to realize this, in the process dramatically raising the prices of stocks and lowering that of bonds.
[Kramer NOTE: Bernstein goes on to explain why moving off gold standard was a good thing, despite the one-time cataclysm]
Although it is difficult to predict the future, it is unlikely that we shall soon see a repeat of the poor bond returns of the twentieth century. For starters, our survey of bond returns suggests that prior to the twentieth century they were generous.
Second, it is now possible to eliminate inflation risk with the purchase of inflation-adjusted bonds. The U.S. Treasury version, the 30-year "Treasury Inflation Protected Security," or TIPS, currently yields 3.45%. So no matter how badly inflation rages, the interest payments of these bonds will be 3.45% of the face amount in real purchasing power, and the principal will also be repaid in inflation-adjusted dollars. (These are the equivalent of the gold-backed bonds of the last century.)
Third, inflation is a painful, searing experience for the bondholder and is not soon forgotten. During the German hyperinflation of the 1920s, bonds lost 100% of their value within a few months. German investors said, "Never again," and for the past 80 years, German central banks have carefully controlled inflation by reining in their money supply. American investors, too, were traumatized by the Great Inflation of 1965-1985 and began demanding an "inflation premium" when purchasing long-term bonds. For example, currently, long-term corporate bonds yield over 7%, nearly 5% above the inflation rate.
Lastly, and I’ll admit this is weak reed, it is possible that the world’s central banks have finally learned how to tame the inflationary beast.
But the key point is this: bond returns in the last century should not be used to predict future bond returns.
