With investors fleeing equity funds because of catastrophic market losses, many advisors are re-evaluating the soundness of their asset-mix strategies. The role of bonds, and government bonds in particular (now that they are acting as a safe haven), has been thrust into the limelight.

At first glance, bonds appear promising. From 1982 through 2008, the DEX universe bond index earned an impressive 10.5% compound annual return, outperforming the S&P/TSX composite index. The annual real return for bonds was 7.3% per annum, rivalling the long-term real return generated by equities.

The cause of this stellar performance was disinflation. As annual inflation rates fell from 12.2% in 1981 to 1.2% in 2008, bond investors, who demand an incremental yield to compensate for expected inflation, earned a windfall real premium as monetary authorities unexpectedly brought inflation down to low single digits.

However, this is only part of the story. The bull market in bonds was preceded by a prolonged bear market from 1946 through 1981. As inflation increased during this period, real bond returns were eroded. In the U.S., intermediate-term government bonds suffered a negative 0.8% annual real return during this bear market, vs the 5.8% annual real return they subsequently earned in the bull market. Over the entire bear and bull period, intermediate-term government bonds earned a 1.9% annual real return.

The truth is that once inflation is factored out, bond investors are modestly compensated. Over the 82-year period from 1926 to 2008, intermediate-term U.S. government earned a 2.4% real annual return. Long-term corporate bonds, facing greater default and interest rate risk, fared slightly better with a 2.8% annual real return. Bonds lend stability to a portfolio, but the price of lower risk is lower real returns.

The flight to quality today has reinforced the modest return outlook for government bonds. The expected nominal return of a government bond is closely approximated by its yield to maturity or its current yield if it is trading near par. In an analysis conducted by my firm, Tacita Capital Inc. of Toronto, we found that the correlation since 1926 between intermediate-term government yields and the subsequent five-year realized return was a robust 0.89. By this metric, the current yield to maturity of the DEX all-government bond index of 2.8% is a harbinger of diminutive future nominal returns, while the DEX universe bond index’s yield to maturity of 3.4% offers little more.

Advisors must consider this low return expectation, as well as risk, in asset-mix recommendations. At a time when central banks are printing money, it would take only a modest uptick in inflation from 2008’s 1.2% to erode real returns to negligible or even negative levels.

These low expected returns also mean that advisors must seriously evaluate the expenses associated with bond investments. The efficiency of the investment-grade bond market in Canada reduces the ability of any manager to outperform the index. My firm analyzed the returns of 69 Canadian bond funds from 2001 to 2008 and found that not one fund outperformed the DEX universe bond index. The drag of expenses was simply too large.

Fortunately, there is a range of low-cost options available today. To gain exposure to government bonds, advisors can invest directly through laddered bond strategies. Several fund companies have introduced low-cost bond funds, while ETF providers have launched a diverse range of options with annual managements fees as low as 0.15%. In the new world of low bond returns, high MERs just won’t cut it. IE

Michael Nairne is president of Tacita Capital Inc. of Toronto, an investment counselling firm.