Journal Papers

Whither Bonds After the Demographic Dividend?

By Rob Arnott

MARCH 2015 Read Time: 30 min


Arnott coined the expression “3-D hurricane” in 2009 to describe the interconnected impact of large deficits, high levels of debt, and shifting demographics on future long-term economic growth and capital markets. The hurricane analogy is very accessible—everyone understands the strength of a hurricane and the destruction it leaves in its wake. The destruction Arnott refers to is the damage to economic growth, and the eventual negative consequences for valuation levels of mainstream stocks and bonds (First and Second Pillar assets), from these three forces. The good news is that investors can find higher future returns in Third Pillar assets.

Virtually all developed nations are in the path of this hurricane. While the United States has a healthier demographic profile than most of the developed world, its reliance on debt-financed economic growth places it squarely in the path of the hurricane. The U.S. deficit has officially shrunk to roughly 3% of GDP, but that official tally overlooks unfunded entitlements (Social Security, Medicare, and Medicaid), off-balance-sheet spending (contributions to the Social Security and Medicare trust funds, and the nation’s overseas military adventures), as well as rising debt obligations of government-sponsored entities (GSEs). Generally accepted accounting principles (GAAP) do not allow a corporation to sweep future promises or off-balance-sheet obligations under the rug—these activities would land corporate executives in jail—but the government proceeds undeterred. The true U.S. deficit, under GAAP reporting, has averaged roughly one-third of U.S. GDP for the past half-dozen years.

As a result, the official debt level, which now exceeds 100% of U.S. GDP, is only the tip of the iceberg. Total U.S. government debt should include federal, state, and local debt, plus unfunded obligations of GSEs; this tally now tops 180% of GDP. Total government debt should also include the vast unfunded liabilities of our entitlement programs: Social Security, Medicare, and Medicaid. Considering these very real promises from the government to the American people brings the nation’s total debt to over 650% of GDP. With government tax receipts running about 20% of GDP, this means that our true national debt—including promises of future entitlement spending—is more than 30 times the government’s annual “income.”  Could any individual carry such a debt burden?

As if the double-whammy of debt and deficits isn’t scary enough, demographics amplifies the strength of the coming storm for the G-8 nations. These populations are aging rapidly as Baby Boomers pass middle age (all are already in their 50s and 60s) and enter their golden years. Mature workers in these age cohorts are in their peak earning years, meaning that society highly values their contribution to GDP, which exceeds that of younger workers. The fastest productivity growth, hence GDP growth, is associated with workers in their 20, 30s, and early 40s. With the size of these younger age cohorts falling, GDP growth in the developed economies of the world is now long past its peak.

Research by Arnott and Chaves (2012)* identifies this GDP link, and also explores the linkage between demographics and the performance of stocks and bonds. Stocks perform better when the number of people in the 35–59 age cohort is large, and worse when the under-30 or over-65 age cohorts are unusually large. Bonds’ peak performance follows that of stocks, with roughly a five-year lag. For example, Arnott and Chaves find that every 1% increase in population share of the 45–55 age group boosts annual stock market returns by 1%. For this same age group, the impact of population change on bond returns is approximately half that of stocks, but still substantial.

Arnott makes the case that the 3% GDP growth rate conventionally accepted as “normal” is, in fact, overstated by approximately 1%, making the normal GDP growth rate closer to 2%. The United States has enjoyed the higher rate of growth as a result of the demographic tailwind produced by the Baby Boomers who were in their 20s to early 40s from the 1970s through the 1990s. Today, the nation is facing a demographic tailwind as the Boomers retire.

In the long run, the natural real interest rate is the real GDP growth rate less a savings factor. Demography influences the savings rate, just as it does the growth rate. Today, the legions of mature working-age adults in the G-8 nations are aggressively saving in preparation for fast-approaching retirement (keep in mind that pensions are a form of savings). This demand has fueled the lofty valuation levels of the last 15–20 years, but it will reverse in the coming decades as the Boomers move from saving to dissaving. Meanwhile, bonds are serving as a form of insurance against the downside risk of stocks. With bonds playing that role, it will not be surprising if Boomers are content to earn a negative real return in order to buy that “insurance” and the resulting peace of mind. The combined impact of prolonged slower growth and strong demand for bonds should keep real interest rates low, or even negative, in developed economies for many years to come.

Arnott points out that the G-8 nations’ large sovereign debt burdens will need to be addressed in some manner. Three options present themselves: paying down outstanding balances, defaulting (probably by changing the rules for entitlements, with means testing and later eligibility), or debasing the currency. In the United States, the latter two options are the most likely, cutting the real value of outstanding obligations as well as the real investment return prospects for fixed income assets. The emerging markets will not be facing the 3-D hurricane for another 10–30 years, offering investors the likelihood of higher expected real interest rates. Other noncore asset classes, such as high yield bonds, TIPS, and REITs, can also help investors hedge their inflation risk.

*Arnott, Robert, and Denis Chaves. 2012. “Demographic Changes, Financial Markets, and the Economy.” Analysts Journal, vol. 68, no. 1 (January/February):23–46.

Summarized by the author.

Featured Tags

How to Invest

Select filters Strategies, Asset Classes, Regions


Asset Classes


Learn More About the Author

Chairman & Chief Executive Officer