As investors rush into U.S. Treasuries in response to a weakening economy that may portend the onset of deflation, this begs the question whether there is a superior deflationary hedge. History can be instructive in this regard. During the Great Depression of the 1930's, a decade where prices fell at an average annual rate of 2.1%, the winning investment was not Treasuries – it was high grade corporate bonds. As illustrated in the following chart, high grade corporate bonds (in blue) achieved an annual return of almost 7% while long-term and intermediate-term U.S. government bonds (in green and red) had annual returns of 4.9% and 4.6% respectively.
High grade corporate bonds outperformed both intermediate and long-term government bonds in six of the ten years in the decade. As illustrated in the graph on the following page, which depicts 12-month rolling returns for all three bond types as well as the annual inflation rate (in pink), corporate bonds (in blue) really only underperformed materially during the heart of the contraction in 1931 and 1932. Even in the severe recession of 1937-38 that triggered a second deflationary cycle, corporate bond performance remained positive.
The performance of high grade corporate bonds traces to two factors. First, as illustrated in the following chart, bond yields fell dramatically over the decade as deflation took hold. This drove up bond prices.
More importantly, although bond defaults by companies skyrocketed during the 1930's, the extraordinarily high default rates occurred in speculative bonds. For example, in 1933 speculative bonds suffered a 15.4% default rate. In comparison, investment grade bonds had a 0.8% default rate, well above normal but comparatively modest. Appendix I at the end of this Commentary sets out the percentage default rates by credit rating for each year during the 1930's.
