There’s a skeleton lurking in the UK’s financial closet. It’s the ghostly remains of a terrible bear market – one that makes Japan’s 31-year stock stagnation look like a temporary blip. This multi-decade decline was the UK’s ugliest bond market crash (and we’ve had a few).
It took 40 years to reach rock bottom. Losses peaked at -79% in 1974. Full recovery took until 1997 – over two decades later.
The whole horror show lasted more than 62 years and unfolded like this:
Data from JST Macrohistory1. February 2023.
Note: This chart – and this entire article – uses real returns2 that incorporate reinvested income.
The two sides of the graph form a jagged hell mouth that swallowed bond investors in the 1930s.
The magnitude and duration of the drop should dispel forever any notion that bonds are inherently ‘safe’.
Bonds are risk assets. It’s the often-divergent nature of their risk – as opposed to any supposedly invincibility – that can make them a useful complement to equities.
Well… sometimes.
The great bond market crash of 1935-97
A log view of the same chart shows how each downward leg of the bond market crash compares:
The -46% ledge-drop of 1972-74 alone was deeper than many stock market implosions.
But we must go further back – to the aftermath of World War One – to find the dark roots of this nightmare.
The trauma of that war gave way to mass unemployment as the Government cut spending and raised interest rates. Its priority was to recover Britain’s preeminence in international trade, and it was prepared to sacrifice the living standards of the general population to achieve that goal.
As wages and demand fell, Britain was wracked by deflation during the 1920s and early 1930s.
Deflation is like steroids for bonds – real yields rose, propelling gilts to a 480% return from 1921 to 1934.
But the Great Depression and unemployment as high as 22% put paid to the Treasury’s tough medicine – the market pushed Britain off the Gold Standard as the Bank of England’s reserves drained.
Yet ironically, the forced policy-reversal proved a blessing (and not for the last time).
The abandonment of the Gold Standard devalued the pound and gifted the Chancellor the freedom to cut interest rates. The resultant cheap money stimulated the economy3 but it also sparked inflation back to life.
And inflation is the arch-nemesis of bonds.
Inflation nation
Our next graph shows how surging inflation triggered gilt losses, while decelerating inflation eventually precipitated the bond market’s recovery:
The sharp spikes in the green annual inflation line correlate with a collapse in bond values. A recovery only began in the 1980s when the general trend pointed down.
If this were a game of Cluedo then it’s case closed. It was RPI inflation that did it, clobbering bonds over the head with the ‘basket of goods’ on the trading room floor.
The 60% loss incurred by 1956 is directly connected to the accelerating inflation that erupts on the chart from the late 1940s. That inflation reached double digits in 1952.
When Prime Minister Harold Macmillan said, “You’ve never had it so good,” he clearly wasn’t addressing bond investors.
The 1960s did provide some relief. Both inflation expectations and gilts drifted sideways.
But then inflation exploded. It jumped over 9% in ’73, 16% in ’74, and peaked at more than 24% in ’75.
1974’s -27% loss inflicted the third largest annual bond defeat of all-time (after 1916 and 2022).
The UK’s worst stock market crash reached its nadir that same year – but by New Year’s Eve the worst was over, despite inflation remaining in double figures for the rest of the 1970s.
A key takeaway from the chart is that nominal bonds aren’t crushed by high inflation per se.
Gilts made an annual gain of 11% in 1975 even though inflation was 24%, for instance.
Why? Because inflation wasn’t as high as the market had feared, and bond yields had already risen to compensate.
Do you yield?
The following long-term yield chart for the bond market crash period proves that investors aren’t defenceless in the face of inflation:
The graph tells us three things:
As bond prices fall yields rise. It’s the law. (It’s also maths).Investors’ demand higher yields to protect their returns against galloping inflation. The stage is set for outsized bond returns if yields outpace future inflationary risks – and especially if interest rates trend down after you’ve locked in a good yield.
Back in 1935 the long-term yield was 2.9%. As yields spiralled they inflicted capital losses that – coupled with soaring inflation – explain the damage sustained by long-term legacy gilt holders:
Year
Yield
Cumulative loss
1951
3.8%
50%
1956
4.7%
60%
1974
15.2%
79%
Fast-rising gilt yields – accompanying inflation breaking loose in 2022 – similarly administered a -30% bond shock last year.
Peak yield
Back in 1975, the yield had already dropped down to 14.6% as inflation crested. That crumb of comfort meant a small 11% bump in bond prices that year – just about visible as the beginning of the recovery in the gilts vs inflation chart above.
Inflation can remain blisteringly high when we think of it as consumers. But it is high and unexpected inflation that pains us as bondholders.
Inflation and yields trended down through the 1980s and 1990s, and at last those 1934 bondholders saw a positive return for the first time. Or perhaps their grandkids did.
As unseen Movietone News commentary of the era put it with characteristic plumminess:
Yes, it’s 1997! New Labour sweeps to power ending 18 years of Tory rule, and Aqua’s Barbie Girl is top of the Hit Parade!
Meanwhile, the class of ’34 are going bond bonkers! They’ve earned 3.4% in 63 years, or a whopping 0.05% annualised. The lucky blighters!
Movietone was not known for the depth of its financial analysis.
Survivor’s gilt
As benighted as the path was for investors caught in the jaws of that great bond bear market, anyone brave enough to bet on a comeback in the 1970s was set to earn equity-like returns.
Buying into 1975 gilts delivered annualised returns of 5.7% over the 10 years, and 6.5% over 20 years.
1982 rolling gilt returns were 9.3% annualised for the next decade – and 8.5% over two decades.
Which, incidentally, is a clue as to why it’s so tricky to call the bond market now.
If inflation subsides, you could be locking in a good yield that’ll deliver decent returns in the future – including substantial capital gains if interest rates fall.
But if inflation continues to go rogue then our nominal bonds will be as useful as a woolly bath.
What to do? We’ve previously explained why every asset class has a place in a diversified portfolio.
It’s best to spread your bets when reckoning with uncertainty.
Take it steady,
The Accumulator
Postscripts
P.S. It’s worth reiterating: this article uses inflation-adjusted total returns to understand exactly what investors’ earned during the bond market crash. Bond articles that don’t deal in real returns do their readers a disservice. For example, the 1935 bond bear market covered above is fully recovered by 1941 when judged in nominal terms.
P.P.S. The second most hideous UK bond market crash began in 1898 and hit -71% in 1920. Those investor’s were made whole by 1932, thanks to that deflationary bond bull market that followed World War One.
P.P.P.S. There’s one grim path that sees 1879 bondholders still underwater 102 years later in 1991. Their returns are perfectly respectable until World War One ruins them. They claw their way back into the black during the deflationary era, but the 1974 FUBAR leaves them staring at a loss again. Finally the 80’s bond boom pushes them back into positive territory where they remain today.
P.P.P.P.S. For a grounding in the mechanics of bonds, please read our pieces on rising bond yields and bond duration. We also have a handy jargon-buster that clarifies some bond terms that are useful to know.
Òscar Jordà, Katharina Knoll, Dmitry Kuvshinov, Moritz Schularick, and Alan M. Taylor. 2019. “The Rate of Return on Everything, 1870–2015.” Quarterly Journal of Economics, 134(3), 1225-1298.Real returns subtract inflation from your investment results. In other words, they’re a more accurate portrayal of your capital growth in relation to purchasing power than standard nominal returns.Triggering a housing boom which left us the legacy of countless streets of 1930s semi-detached properties that still make wonderful homes today.
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The untold story of the UK’s worst bond market crash.
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