Why investors are best advised to be wary of bonds

Bond investors shouldn't be scanning the skies for helicopters; the steamroller they stand before is getting closer.

Picking up nickels in front of a steamroller is the classic market metaphor for any strategy that offers low and usually stable returns but with the small risk of catastrophic failure.

Yet it is the prospect of "helicopter money," the direct financing of state spending by a central bank, potentially through the issue of perpetual noninterest-paying debt, that obsesses markets. Reports that Ben Bernanke, one of the intellectual fathers of the idea, had consulted with Japan about the possibility moved the yen and other markets sharply last week.

Reuters sources were quick to pour cold water over the notion, pointing out, among other things, that direct financing by the Bank of Japan is illegal under Japanese law.

But with more than $13 trillion of sovereign debt carrying a negative yield, investors do not need helicopters to rain down money, much less hyperinflation, in order for their bond allocations to come to grief.

Investors, as a general thing, hold sovereign bonds in their portfolios not because they expect them to outperform but because of other admirable qualities they have historically displayed. Their yield serves as a steady stream of income, and as an asset, class bonds have a stabilizing effect on portfolios, moving generally in the opposite direction of other assets during times of stress, and usually with less violence.

One of those qualities — yield — is mostly no longer true. The other, diversification, is also more doubtful than perhaps it has ever been.

To be sure, bonds have rallied this year and have played their traditional role as portfolio ballast during bouts of market instability. It is hard, however, to extrapolate forward and expect this quality, of stabilizing returns, to persist. The nickels are getting smaller and fewer, and with the steamroller approaching, the risks are very asymmetric. We might get more rallies in bonds, but the potential for devastating loss, or just long-term lousy performance, seems much larger.

Chris Brightman, chief investment officer at Research Affiliates, argues that ever more extreme monetary policy and negative real rates have undermined government debt's role as the signifier of the risk-free rate, a concept at the heart of both portfolio construction and security valuation.

According to Research Affiliates' assumptions, the expected 10-year real return is about half a percent a year for core bonds, and even a 60/40 domestic equity and bond portfolio will make only about 1.2 percent a year in real terms.

"Do we define guaranteed failure to meet our investment objective as the absence of risk?" Brightman writes in a note to clients.

"History teaches, however, that a sustained regime of financial repression — an intentional policy of sustained negative real interest rates imposed for the purpose of inflating away the real value of debt — eventually produces high and volatile inflation. During periods of financial repression, government bonds are hardly risk free."

Those are problems for policymakers, but investors face significantly different issues. Surely, causing a kind of revulsion away from sovereign debt may even be part of the solution, as the idea of very low rates is in part to get investors to deploy capital in areas that will lead to higher growth.

Investing in an asset class simply because it has always been a core part of a portfolio, despite the fact that we've never before faced a similar economic situation, seems like the kind of thing that will feel, in retrospect, foolish.

That's not to say that investors should abandon bonds, much less cash, entirely.

Look out, though: The nickels are few and far between, and the steamroller isn't getting any lighter.