Government bonds are far too risky for retail investors

Australian government bonds returned about 10.1 per cent in 2014, easily beating Aussie equities, which were up less than 1 per cent on capital gains alone (or up 5 per cent on an accumulation basis). Elsewhere, returns on cash deposits continue to fall, with rates between 1-3.4 per cent, according to the RBA.

Moreover, the market has ongoing concerns about how well our stocks can perform in 2015 as China slows. Against that backdrop, the natural tendency for retail investors may be to turn their gaze toward the government bond market.

It would make sense given recent trends. These thoughts are logical. Government bonds are regarded as being much less risky than equities -- the risk-free asset, according to some. Moreover, returns have been impressive for such a riskless adventure.

Over the last decade bonds have returned 82 per cent, which compares well to equities at 104 per cent on an accumulation basis. Indeed since 2010, bonds have narrowed that gap, rising 39 per cent. This is equivalent to the gains made by Aussie equities, which don't have the advantage of being ‘risk free'.

Now these aren't bad returns. Nor am I suggesting that we won't see a repeat performance in 2015. Bonds could easily put on another 10 per cent over the next year, although they may not and indeed no one should expect them to.

The real issue for retail investors -- the big problem -- is that government bonds are far from risk free. 

Consider that the great bond rally since the GFC has been driven by an orgy of money printing by the world's major central banks: the Fed, the Bank of Japan, the Bank of England and the ECB. These are the biggest players in the global bond market alongside state-owned wealth funds.

The key driver behind the bond market is the decision (of central banks) to print money. This is not something retail investors are going to get the heads up on. Remember, bond funds provide capital exposure. You want the bond yield, then you have to hold it to maturity. In the interim, if bond prices fall (yields rise), you can lose money.

The problem investors have is that central banks are proving to be very reluctant to stop the printing presses. This is understandable as it provides governments with free money. It's much easier to continue to print money than cut spending or raise taxes. Options that government could use to shore up balance sheets rather than money printing. The choice over these, however, is purely political - there is nothing economic in it. Purely on the basis of the economics, no central bank would be printing. The threat of depression has passed and there is no risk of deflation.

On that basis, the most rational expectation is that a normalisation will occur at some point and that bond prices will fall. Again, they may not, but it will be politics that determines the outcome. There must be a limit to the lunacy somewhere along the line, although the duration of it has stunned many. Yet no one knows when this will be. On the economics of it, rates would have been normalised some years ago. But governments of the major economies are in a race to the bottom, dragging their feet and dispensing with prudent policymaking. 2015 might be the year, or it might be 2016.

 Investing is risky enough without relying solely on the whim of bureaucrats and politicians, for returns. Sure, equities are subject to the fancy of policymakers, but less so over the medium term. Underpinning the stockmarket's performance is a strong global rebound in corporate earnings growth. Rates normalisation may disrupt that temporarily, but it can't derail it.