In the wake of the 2007-2009 bear market, investors have poured hundreds of billions of dollars into fixed income in an effort to reduce the risk of their portfolios while seeking to earn a more stable if more modest return on their money (see www.ici.org). So far, it seems to have worked out okay. For example, since the bear market low of March 9, 2009 through the market’s most recent close of May 6, 2011 the Barclays Aggregate Bond Total Return Index is up 16.82%. Sure, it’s not the 107.02% earned in the S&P 500 Total Return Index over the same time, but it hasn’t lost money in nominal terms.
However, as pointed out by Greg Mankiw, professor of economics at Harvard University, fixed income is not without serious risks in the coming years.
A remarkable feature of current financial markets is their willingness to lend to the federal government on favorable terms, despite a huge budget deficit, a fiscal trajectory that everyone knows is unsustainable and the failure of our political leaders to reach a consensus on how to change course. This can’t go on forever — that much is clear.
Less obvious, however, is how far we are from the day of reckoning.
Winston Churchill famously remarked that “Americans can always be counted on to do the right thing, after they have exhausted all other possibilities.” That seems to capture the attitude of the bond market today. It trusts our leaders to get the government’s fiscal house in order, eventually, and is waiting patiently while they exhaust the alternatives.
But such confidence in American rectitude will not last forever. The more we delay, the bigger the risk that we follow the path of Greece, Ireland and Portugal. I don’t know how long we have before the bond market turns on the United States, but I would prefer not to run the experiment to find out.
Furthermore, I suspect that many fixed income investors would be shocked to learn that historic drawdowns in fixed income-in real terms-have been larger and longer than the drawdowns in equities.
Posted by Andy Hyer 
