Where I live in South Florida, we are in the early stages of hurricane season. In hurricane zones, they talk about the “dirty” side of the storm, the part that trails behind the storm’s eye. It contains some of the nastiest weather and greatest destruction. The dirty side of the 32 year bull market in bonds is getting closer.

That’s not bad news if you have an approach that is specifically crafted to sidestep that oncoming storm . But if you are a bond fan because you enjoy earning income, or because you are an advisor with many years invested in promoting strategies like “60% stocks, 40% bonds” you have a critical, long-term choice to make. Do you seek shelter or do you endure the dirty side of the storm?

Each month our friends at the Leuthold Group provide their subscribers with the price return and total return on different types of high-quality bonds since 1981, the year in which U.S. interest rates peaked. For 32 years, it has been all downhill for yields, which means all up-hill (good thing) for bond prices. As I have blogged recently, that game is OVER, except for some brief periods of declining yields along the way.

As Leuthold points out in their July “Greenbook”, the average annual return on bonds attributable to price increases, NOT the income payments, since the 1981 secular low in bond prices is as follows (data through 6/30/13):

10 YEAR TREASURY BONDS 2.2%

20 YEAR TREASURY BONDS 3.3%

LONGEST MATURITY T-BONDS 3.7%

HIGH QUALITY CORPORATES 3.5%

MUNICIPALS (G.O.-20 year) 2.9%

These figures are the average boost one received in their bond holdings from falling interest rates. Add this to whatever income yield your bonds produced and there’s your annualized total return from the bonds.

That’s the history. Going forward, the benefits of high-quality bond investing will likely be limited to your income yield. As interest rates rise, bond prices fall. As this occurs, those boosts noted in the chart above simply vanish…or turn negative. My guess is that on a multi-year basis, high-quality bonds are grossly overpriced, and it will take years to work off that excess.

What does that mean in numbers? Take the 20-year bond (please, because I don’t want it!). Its annualized return since 1981 is 9.9%! That brings two pieces of bad news for bond investors:

  1. The price gain portion of the last 32 years (3.3% per year) is unlikely to be repeated. How bad could it get? In 2009, the price portion of the 20 year bond fell 18.8%. The price of the 30 Year T-Bond price fell 29.1%. That’s not the worst-case, it is just the worst calendar year of the past 10.
  2. The yield implied by that 20-year bond total return is 6.6%. The current yield on 20-year bonds is a mere 3.1%. So that portion is also going to be much lower.

So, what has produced 9.9% a year on average for 32 years is looking more like a return of at most 3.1% per year in the future. Talk about a culture shock!

The implications are enormous. But don’t tell that to the bond fans. They are still showing their clients 3/5/10 year historical returns through the end of 2012, where most measures of bonds’ total return resembled that of a stock portfolio. This was a fortunate reality for those who were invested heavily in bonds, but it is a mirage for those who are looking forward from here. They don’t realize it, but they are currently in the eye of the storm. The dirty side is probably right behind it.

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