What types of bonds deliver the best returns?

Indeed, while investors have exited equities along with the downturn in that sector, many have sought safety in short-term debt holdings such as money-market funds.

No longer are we in the days of what Wall Street calls TINA (There Is No Alternative to stocks). Instead investors are welcoming the days of TARA (There Are Reasonable Alternatives) with bonds.

With that in mind, we decided to investigate fixed-income returns over the past 50 years to determine which sections of the bond market have done best on a risk-adjusted basis. To sum up: U.S. long-term bonds led the field and outperformed U.S. dollar-denominated international bonds by a healthy margin. But if you are worried about continued rate increases, you might want to position yourself in short-term U.S. debt.

To examine this issue, I asked my research assistants Renzo Luna Victoria and Qi Zhang to pull all mutual-fund fixed-income data over the past 50 years. We then separated the fixed-income data into their respective concentrations: U.S. ultrashort term, fixed income (diversified), international bonds, U.S. short term, municipal debt, U.S. long term and GNMA (mortgage debt). We then calculated the average return, median return and average volatility of each grouping over the full 50 years, when rates were rising and during recessions.

The first interesting finding is that U.S. long-term debt had the highest average annual return of any bond category over the long run. Most subcategories of bonds lined up in terms of having similar risk-reward profiles (i.e., those with higher returns exhibit higher risk). International debt denominated in U.S. dollars, however, was an outlier at the low end of the spectrum. The average U.S. long-term-debt fund delivered an annualized return of 7.68% with annual volatility of 7.44%. The average dollar-denominated international bond portfolio delivered 6.38% with volatility of 7.47%. U.S. long-term debt thus topped international by more than a percentage point, and with less volatility.

It should also be noted that municipal debt fared better than the dollar-denominated international debt on a risk-adjusted basis as well, once you take into consideration the tax-deductibility of muni debt. The average municipal-bond fund delivered a return of 5.60% with a volatility of 5.58% over the period. Once factoring the tax hit on a portfolio of the international bonds (depending on the marginal tax rate you use) municipal debt has at least a 0.5-percentage-point advantage, again with a lower volatility.

Next, we decided to examine the results during rising-rate environments. Not surprisingly, the results totally flip. Now, ultrashort-term U.S. debt is by far the best option. Ultrashort-term debt recorded an average annualized return of 4.20% with a minuscule volatility of 1.11% when the Federal Reserve was raising rates. It scored the highest average return out of all the options and the lowest volatility. You really cannot come close to beating ultrashort-term debt when rates are going up.

Finally, we also examined the results during recessions. Here we see a newcomer, GNMA (mortgage/mortgage-backed securities) debt, along with U.S. long-term debt doing the best on a risk-adjusted basis, again doing better than world debt—average annual returns of 11.46% (GNMA) and 11.16% (U.S. long-term debt), compared with 9.71% for international bonds.

In total, U.S. long-term debt has done significantly better than international debt over the past 50 years on a risk-adjusted basis. But if you are worried that the Fed will continue its rate increases well into 2023, past results suggest that you really cannot do better than U.S. ultrashort debt.