Morningstar - Q1 2023 - 51

Bonds and Inflation: June 1979-March 1980
I now turn to the two worst periods for
long-term bondholders to see what lessons we
can learn from them. The second-worst period
was June 1979-March 1980. EXHIBIT 3 shows
yields and cumulative values (set to $1 in
June 1979). Over this short period, five-year bond
yields rose from 8.64% to 12.85% and 20-year
bond yields rose from 8.77% to 12.39%. This
led to the cumulative value of $1 invested
in 20-year bonds in June 1979 falling to $0.80 in
March 1980 for an annual rate of return
of negative 26.06%. Over the same period, $1
invested in five-year bonds fell to $0.92 for an
annual rate of return of negative 10.73%. Inflation
over this period was a whopping 14.64% per
year. Hence, while Treasury bills had an
annual rate of return of 11.29%, they fell below
inflation by 2.92%.
These results show how in less than a year,
high inflation and rising bond yields can
wreak havoc on fixed-income investments. But,
as bad as 1979 and 1980 were, the recent
rise in inflation and bond yields has led to even
worse performance for bonds.
Bonds and Inflation: March 2020-October 2022
As EXHIBIT 4 shows, the COVID-19 pandemic
ushered in the worst period in history for longterm
bonds in terms of cumulative value: $1
invested in March 2020 was worth only $0.62 in
October 2022 for an annual rate of return
of negative 16.71%. Over the same period, $1
invested in five-year bonds fell to $0.87 for
an annual rate of return of negative 5.43%. This
was a period where 20-year bond yields rose
from 1.14% to 4.52%, five-year yields rose from
0.50% to 4.33%. Also, after a long period
of near-zero inflation, inflation was 5.51% per
year. Treasury bills rose to only $1.01 for an
annual rate of 0.35% and a real return of negative
4.89%. Once again, Treasury bills failed as a
hedge against inflation.
I am writing this in November 2022, so I only
have month-end data through October
2022. In the coming months, it is quite possible
that inflation will continue, yields will rise,
and bonds and bills will continue to do poorly.
Fixed-income investors concerned about
future inflation need an inflation-proof
alternative to bonds that pay fixed
nominal amounts. These alternatives are
inflation-linked bonds.
Inflation-Linked Bonds
The payments of an inflation-linked bond are
adjusted by the Consumer Price Index
(cumulative inflation) so that their real values
remain constant over the term of the bond.
Inflation-linked bonds are typically issued
by the government. They go by various names,
depending on the country of issue. In the
United States, they are called Treasury InflationProtected
Securities, or TIPS.
An interesting point about inflation-linked
bonds is that their yields are the real
interest rates of the Fisher Identity. Before
the advent of inflation-linked bonds, real
interest rates had to be estimated from observed
nominal rates and models of expected
inflation. Now, real interest rates can be observed
because they are the yields on inflationlinked
bonds.
EXHIBIT 5 shows how well TIPS, represented
by Morningstar indexes, did over the recent period
of rising inflation and nominal bond yields
(March 2020 to October 2022). The exhibit shows
the cumulative values of three TIPS groups
EXHIBIT 3
The Second-Worst Period for Bondholders, June 1979 to March 1980
Historical Bond Yields
14%
14%
12
12
8
8
06/1979
09/1979
12/1979
03/1980
0.80
0.90
1.00
1.10
0.70
Inflation
1.11 (14.64%)
0.80
0.90
1.00
1.10
0.70
06/1979
Source: Morningstar Direct.
09/1979
12/1979
03/1980
30-Day
Treasury Bills
1.08 (11.29%)
Inflation
1.11 (14.64%)
30-Day
Treasury Bills
1.08 (11.29%)
06/1979
09/1979
12/1979
03/1980
20-Year Bond
0.80 (-26.06%)
5-Year Bond
0.92 (-10.73%)
20-Year Bond
0.80 (-26.06%)
5-Year Bond
0.92 (-10.73%)
Cumulative Values of Bonds and Treasury Bills, and Cumulative Inflation (Compound Annual Rates
of Return in Parentheses)
$1.20
$1.20
10
8.77
8.64
10 06/1979
8.77
8.64
09/1979
12/1979
03/1980
5-Year Bond
12.85
20-Year Bond
12.39
5-Year Bond
12.85
20-Year Bond
12.39
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51
Cumulative Value
Cumulative Value
Yield
Yield
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