Why Bond Market Outperformance Is So Tough

Last Updated Feb 10, 2010 9:43 AM EST

As I mentioned on Monday, there's increasing evidence that outperformance in the bond markets is just as difficult as in the equity market (if not more so). Market efficiency shows why that's the case. Let's see why this is true.

First, with U.S. Treasury debt, all bonds of the same maturity will provide the same return. Thus, there will be no differentiation in performance and no ability to add value via security selection.

Second, there's some chance to add value when investing in corporate debt, but not much, at least with high-quality bonds (the only kind you should invest in). Consider two companies with AAA-ratings: Johnson & Johnson and ExxonMobil. While it's quite possible their stocks will perform very differently (providing at least the opportunity for active management to add value), it's highly unlikely the returns on their bonds of similar maturity will vary much. The result is that there's an extremely limited ability to add value via security selection -- because credit risk is very low. (Note that the lower the credit rating, the more potential there is for dispersion of returns between bonds of the same credit rating and maturity.)

Since there's little (with corporate bonds) to no (with government bonds) ability to add value via security selection, that leaves interest-rate forecasting as the only way an active manager might add any significant value. William Sherden, author of the wonderful book The Fortune Sellers, reviewed the leading research on forecasting accuracy from 1979 to 1995 and covering forecasts made from 1970 to 1995. He concluded that:

  • The forecasting skill of economists is about as good as guessing.
  • There are no economic forecasters who consistently lead the pack in forecasting accuracy.
  • Consensus forecasts don't improve accuracy.
Since the underlying basis of interest rate forecasts is an economic forecast, the evidence suggests that bond market strategists who predict bull and bear markets will have no greater success than do the economists. If active managers are highly unlikely to add value via either security selection or market timing, the only conclusions we can draw are:
  • That the conventional wisdom of active bond management as the winning strategy is wrong
  • That the markets are highly efficient
Once we conclude that the market is efficient, the winning strategy becomes clear: Be a passive buy-and-hold investor using only low-cost investment vehicles to implement the investment plan.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.