Risk- free reward gives way to reward- free risk

I wouldn’t exactly classify myself as a bond bear. After all, the world’s major central banks have deeper pockets than I do and their incursion into the fixedincome market has left them holding more than 30 per cent of the outstanding sovereign debt on their balance sheets.

There is also no doubt in my mind that had the U. S. Federal Reserve in its QE3 program not funded almost half of the U. S. government’s borrowing needs, the yield on the 10- year treasury note would be closer to three per cent or even 3.5 per cent than the current sub- two per cent yield.

Be that as it may, the best opportunities globally for risk- adjusted returns continue to reside in the equity market where, in most cases, the dividend yield is multiples of the government bond yield.

I can totally understand why banks have to own government bonds ( regulatory capital constraints), why pension funds have to own them ( era of de- risking at any price), why insurance companies have to own them ( liability matching purposes) and why central banks have to own them ( get the economy moving).

But why on earth an individual investor would want to own them is a mystery to me, especially since the dividend yield ( let alone the earnings yield) almost everywhere else is so much more compelling.

There are areas of the market that seem to have better potential than the plain- vanilla government bond market — an asset class that in the past offered riskfree rewards and today simply provides reward- free risk.

If you’re buying bonds at today’s puny yield levels, you are speculating on capital appreciation from even more microscopic rates to generate your total return. This is not the bond market of past years or decades when it was the coupon that was alluring.

Today it is the capital gain, which was responsible for almost 90 per cent of the total return at the long end of the government bond curve last year. Compare and contrast that to the S& P 500 where the capital gain accounted for 80 per cent of the total return.

Flipped on its head, this tells you that the income component is becoming less of the core in the bond market’s total return and more so in the stock market, which, again, shows how the world of quantitative easing has created altered states in the realm of financial markets.

But it begs a serious question: Why not be involved more in the asset class that provides a larger income orientation and allows you to share in the upside of an expanding economy, instead of the more limited potential in bonds where the yield is less alluring and you are more exposed to Uncle Sam’s bloated balance sheet?

The bond market had a terrific year in 2014, but that was after a horrible 2013. What the bond bulls do not tell you is that the long bond in February generated something in the order of a minus-seven per cent total return and the 10- year T- note has triggered a minus- three per cent net return.

In other words, the “safe” sovereign bond market lost you money in the past month, at least on paper.

And what did it take? The grand total of a 40- basis- point backup in market interest rates. That’s it.

It’s one thing to experience that in the stock market, where the downside risks are coupled with tremendous upside return potential, but bonds have more limited upside return potential and, as such, losses are unacceptable.

David Rosenberg is chief economist and strategist at Gluskin Sheff + Associates Inc. and author of the daily economic report, Breakfast with Dave.