Bonds' 30-Year Hot Streak Begins to Cool

Investing in Treasurys over the long term is a fine idea -- unless you're sure inflation won't occur anytime soon.

Bonds for the long run, anyone?

In the latest issue of the Journal of Indexes, investment manager Rob Arnott, chairman of Research Affiliates (read article here) says that long-term bonds have beaten stocks for decades.

"Starting any time we choose from 1979 through 2008," Mr Arnott writes, "the investor in 20-year Treasuries (consistently rolling to the nearest 20-year bond and reinvesting income) beats the S&P 500 investor." He argues the figures are even true going back to the late 1960s.

Mr. Arnott's article has generated quite a stir in the investment world, where he has, in theory, turned a lot of received wisdom on its head.

But American mutual fund investors, responding to last year's turmoil, are already voting this way with their wallets. So far this year they've withdrawn $45 billion from mutual funds that invest in the stock market, and put $68 billion into bond funds, reports the Investment Company Institute.

Should you follow suit? Not so fast.

Obviously bonds, especially Treasurys, held up well during last year's crisis. And they can make an important part of a portfolio, especially at the right price. But anyone hoping for a repeat of the last thirty years is probably dreaming.

Treasurys don't look appealing. Short term bonds yield a miserable 1.9%. And long-term bonds, far from offering "security," are actually at serious risk from rising inflation.

The past is the past. Those who bought long-term Treasury bonds in the late 1970s and early 1980s simply pocketed an enormous one-off windfall when inflation collapsed. It neared 15% in 1980. Latest figure: -0.4%.

Consider what that means for investors.

In 1979, 20-year Treasurys yielded 9.3%. So over its life the bond paid out $180 in interest for each $100 invested. At one point in 1981, 30-year Treasurys yielded an incredible 15%, thanks to runaway inflation in the 1970s. Investors demanded high interest rates to offset the expected loss of purchasing power on their money.

But when inflation collapsed after 1982, those coupon payments turned golden because the purchasing power stayed high. Bond prices soared in response.

Today, bond investors get no such deal. Ten-year Treasurys pay just 3%. And the 30-year 3.96%.

If we get a sustained period of deflation, investors will still do well. But that's a bet, not a guarantee.

It's just as likely that we'll end up with a surge in inflation instead. The economy seems to have staggered up from its death-bed (at least for now). And the mother of all fiscal adrenaline hits hasn't even entered the bloodstream yet.

What would inflation mean for long-term bonds?

The opposite of the lucky guy who bought long-term Treasurys in 1981 was the unlucky one who bought one in 1965, just before inflation began to surge.

In 1965, a 20-year Treasury yielded just 4.17%.

In the first year, the coupons on a $1,000 bond were enough to buy about 200 loaves of white bread.

But by 1973 that was down to 151 loaves.

And by 1980: A mere 80 loaves.

The real return over the life of the bond was actually negative. Not only were investors not rewarded for saving -- they were punished. By the time they got their $1,000 principal back in 1985, it bought only a third as much bread as the same amount would have bought in 1965. Even when you factor in the coupons, the investor ended up with less bread than if they had simply taken the entire $1,000 down to the baker's in 1965. And notice we haven't even counted the cost of taxes.

Longer-term Treasurys are often described as "safe" because the coupon payments are secure. But it's only half the story.

Write to Brett Arends at brett.arends@wsj.com