Written By Ethan S. Braid, CFA - 03-28-2013
Avoiding the Bond Bubble
When I first wrote about the bond bubble, it was May 23rd of 2012. On that date I wrote an article titled: “When the Bond Market Blows Up.” The article can be found on my company’s blog site. My analysis at the time was that at a 2.86% yield on the 30 year treasury, there was no value proposition in the bond market. Instead, I encouraged investors to look to the equity markets for more compelling investment opportunities, with many stocks yielding in the 3% - 5% range and the market as a whole undervalued at that time.
Fast forward to today. Since I wrote that article:
- S&P 500 cumulative return (as of 3/28/13) = 21.31%
- Barclays U.S. Agg Bond cumulative return (as of 3/28/13) = 2.18%
- $300 billion more has poured into bond funds in the last 12 months[i]
- $92 billion has exited U.S. stock funds in the last 12 months[ii]
- YTD 2013 Bond funds have gathered $59b, trouncing U.S. stock funds which have only gained $17b in new investor money[iii]
Clearly the 19.13% outperformance of the stock market over the bond market has justified my call back in May of 2012. Yet investors continue to favor bonds over stocks and money is only just now starting to flow back into stock mutual funds as investors attempt to chase the recent stock market performance.
While the bubble in the bond market has not yet burst, signs of hitting the wall are showing up. As of 3-28-13 the Barclays U.S. Agg Bond index was at -.12 for the year. With the 10 year treasury yielding 1.85 and CPI at 2.1[iv], the 10 year treasury has a negative real return (see page 7 of this article for more detail on negative real returns) of 25 basis points. Negative real returns should discourage investors from adding to bonds, but that doesn’t seem to be the case right now. Instead, investors continue to chase the big story of the last 30+ years, sending roughly $20 billion per month into bond mutual funds. Going back to 1975, the Barclays U.S. Agg Bond index has had an average annual return of 8.15% and only two negative return years in that 37 year span. The negative return years were 1994, at -2.92 and 1999 at -.82. Additionally, in 10 of those 37 years the index had returns in the double digits. Thus, in the rear-view mirror, the bond market has had nothing short of an incredible run! As is the case with most investors, rear-view mirror investing is a common practice. The phenomenal long term returns of the bond market and perceived “safety” has attracted tremendous interest in recent years. In fact, since 2008, over $1 trillion of investor capital has been moved into bond mutual funds[v]. This is a staggering number, and people should take note of it.
Why I think we are in a bond bubble
- Over $1 trillion has poured into bond mutual funds since 2008.
- Money continues to chase the bond market, despite negative real returns.
- Investors are still expecting another 2007/08 financial collapse and desire the perceived “safety” and diversification benefit of bonds.
- The past 30+ years have been exceptionally favorable to the bond market.
- The average investor has no understanding of the risks involved with bonds.
- The Fed has lowered interest rates and expanded the money supply in an effort to stimulate the economy – the byproduct of their actions has been an inflation of bond prices.
- From a behavioral finance perspective, investors are exhibiting herd mentality as they group together in bonds for what they falsely believe to be a “safe” investment.
- The vast majority of investors have never in their lifetime experienced a protracted bear market for bonds. 30 years of declining rates have created a false sense of security for bond investors.
Take a look at the chart above. Bond prices move opposite to interest rates. Studying the chart reveals that the trend of the last 30+ years has been exceptionally favorable to bond investments. However, there isn’t much more room for interest rates to drop from here. Gone are the years of easy returns in the bond market from declining interest rates. Ironically, it is at this inflection point, where rates are likely to start moving up in the years ahead, that investors can’t seem to get enough bonds in their portfolios. In many ways, investor behavior today is a mirror image of 1999. Only then they were chasing technology stocks and now they are chasing high yield bonds. Different asset class, same story. Buying an overvalued asset at the worst possible time always leads to portfolio losses.
What is likely to happen to the bond market?
Predicting interest rates is something that very few people can do with any degree of consistency and I profess not be one who can accurately forecast interest rates. However, a careful study of our government’s monetary policy and attitude towards debt, unemployment, interest rates etc. can give us clues about what to expect for inflation and the money supply, which influences interest rates. It is well known that the Fed has taken extraordinary measures in the last few years with respect to the monetary base, total Federal debt outstanding, quantitative easing, and interest rates. The 115% expansion of the monetary base from 2009 – 2011 is unprecedented going back to 1920[vi]. The only other time in the last 93 years we have done anything this dramatic was 1943 – 1945 when the monetary base was increased by 60%. Increasing the money supply in such a profound way will eventually have far reaching consequences. When the velocity (number of times circulated) of the broad money supply, mzm (money with zero maturity), begins to pick up, so too will inflation. Additionally, nominal GDP growth has a perfect correlation to CPI going back to 1901. As the economy improves in the years ahead and nominal GPD increases, so too will CPI. Thus, the perfect storm is in place for inflation to come about in the years ahead – an improving economy and too much growth too quickly in the money supply. Higher inflation will lead to higher interest rates, and higher interest rates will be detrimental to bond investors.
The difference between now and anytime in the last 50 years, is that until recently, interest rates have been much higher, averaging 6.70% for the 10 year treasury since 1963. Thus, the higher interest rates of the past helped offset bond market losses when interest rates rose. For example, the Barclays U.S. Agg Bond Index was able to eke out small positive returns, every year, during the interest rate spike of the late 1970s due to the fact that the bonds in the index were already paying high interest and that high interest + even higher rates on new bonds helped overcome the losses due to price depreciation from interest rates moving up. Such is not the case now. Because rates are so pitifully low, when rates begin to move up, the low interest rates on today’s bonds will not be enough to offset the losses experienced from bond prices falling due to rising rates. The end result may be a string of negative return years for bond investors should interest rates begin to rise in any meaningful way. More importantly, interest rates need only move back up to longer term averages and investors will experience substantial losses.
Here is a wake-up call example to put things into perspective. If interest rates were to suddenly rise, how would the price of a 30 year treasury, trading at par ($1,000 per bond) with a 3% coupon be affected?
- Rates rise to 5% = new price for the bond of $690. 31% LOSS
- Rates rise to 6% = new price for the bond of $585. 42% LOSS
- Rates rise to 7% = new price for the bond of $501. 50% LOSS
Can you see the danger? As recently as June 2007 the 30 year treasury yield was 5.25%. From 1970 to the year 2000 the 30 year bond spent nearly all of those 30 years well north of 6%. Therefore, just getting back to the average treasury yield would be a very painful experience for most bond investors.
The great irony however, is that most investors perceive bonds to be “safe.” Many have underestimated the risk in the bond market or quite simply are ignorant to the fact that bonds can lose money. More important is the potential magnitude of the losses. The average investor is not expecting a potential 40% drop in his bond investments. The average investor isn’t even aware that treasury bonds could drop by such a large percentage. Just like investors were not prepared for housing to begin to drop in 2007 or the tech bubble to burst in 2000, they will not be prepared for the losses coming in the bond market.
Going forward, there are three things that interest rates can do:
- Stay the same.
- Go up.
If you are bond investor today, you will lose in two of those three scenarios. Rising rates will bring sheer misery to most bond investors. Stable rates and stable inflation will equate to no real returns. Only declining rates coupled with significant deflation could bring about strong positive real returns in the bond market. If you are considering an investment and in two out of three scenarios you stand to lose, does that sound like a wise investment to you? Probably not, and yet money continues to chase this asset class.
Now ask yourself, what value was available to investors in 1999 when dot.com stocks were selling for hundreds and sometimes thousands of times what a company’s earnings were (and that was for companies with earnings, many didn’t even have earnings)? Simple answer - none. We all remember how that story turned out too, by 2002 many of the internet darlings had delivered losses on the magnitude of 90%. At that time, many people learned a hard lesson about chasing yesterday’s winner and overpaying for an investment.
The current state of the bond market, investors’ desire to buy bonds at these low yield levels, and the obvious lack of value provided by bonds is a clear signal to me that the end of the great bull market in bonds is near. I have no crystal ball to predict the future, but purchasing an investment that loses money in two out of three base cases is not a smart decision…and yet investors keep piling into bonds like there is no tomorrow.
How to protect your portfolio going forward
Now that we have outlined the risks in the bond market and why you should minimize your bond exposure or avoid bonds entirely, let’s take a look at what makes sense for investment portfolio construction going forward.
Start with strategic asset allocation
The very first step in the wealth management process is to first determine your need for diversification. Wealth is created by taking risks and by concentrating. Wealth is maintained and protected by diversifying. Since my practice is geared towards serving wealthy families who are interested in protecting and growing their hard earned fortunes, this article will focus on wealth preservation strategies and not wealth creation strategies.
I have long challenged the soup du jour asset allocation strategies that seem to be everywhere these days. Pie charts are now en vogue and every brokerage firm has a whole bunch of them they would like to sell to you. Unfortunately, they all seem to be about the same when you get under the hood of those pie charts…buy a little bit of everything and hold on. How is that process value-added? You don’t need to hire a financial advisor or pay a brokerage firm for advice that basic. The biggest problem that I have with the most common of today’s asset allocation techniques is that these strategies are backwards looking when in fact they should be forward looking. The software programs used to model out these pie charts incorporate historical data (standard deviations for example) that helps determine an optimal portfolio mix. No consideration however is given towards the valuation of the asset classes used to fill in the pieces of the pie. This decision point, what the valuation of the asset classes looks like, is where my process differs from most financial advisors and investment managers. I begin with determining a client’s need for diversification, but unlike most financial advisors who then buy every asset class there is, I will only invest in asset classes and investment strategies that look attractive from a valuation or strategy perspective.
Why would you buy something if the outlook was extremely unfavorable? You wouldn’t. Yet today most investors running “diversified” portfolios have a healthy serving of all types of bonds in their pie chart. Corporate bonds, emerging markets bonds, municipal bonds, high-yield bonds, et al. Some of the more savvy financial advisors have put their clients into bond products that are labeled “unconstrained bond funds” which give themselves wide latitude for investment decisions and imply that when the bond panic sets in they will somehow avoid losses. These funds will be taken out with the tide just like everyone else.
So the challenge for investors is to build a properly diversified portfolio that can protect against various risks present in the capital markets but at the same time avoid asset classes that offer no, or little, value. How does one build that portfolio?
Bond replacements & other income ideas
Because we have identified the bond market as very unattractive, we must seek out other investments that we believe offer positive return opportunities and yet still offer diversification benefits relative to stocks. Correlation coefficients tell us to what degree investments move together. For example, a perfect correlation of 1.0 between two investments implies that the two investments will move together, up & down, in unison. Conversely, a perfect negative correlation of -1.0 between two investments implies that the two investments will move in distinctly opposite ways – if one goes up the other will be down and vice versa. Highly positively correlated investments offer little to no diversification benefit and highly negatively correlated investments offer significant diversification benefit. Thus, as part of my analysis for investments within a portfolio, a careful study of the correlation coefficients is a key part of the portfolio construction phase. Ideal investments will have a correlation coefficient of “0” with the stock or bond markets. At a correlation of “0,” the return stream from such an investment will not be influenced by the stock & bond markets. Thus, you could be making money regardless of what the stock or bond market is doing. Here are some strategies and asset classes where you may find investment opportunities with low, 0, or even negative correlation coefficients to stocks & bonds:
- Convertible bond arbitrage
- Managed Futures
- Market neutral strategies
- Fund of Funds
- Merger arbitrage strategies
Well run convertible bond arbitrage, managed futures and fund of funds strategies will have a positive correlation to the stock market but will be low enough in correlation that they will offer plenty of diversification benefit and will also help to reduce overall portfolio volatility.
Market neutral and merger arbitrage strategies will have 0, or near-zero, correlations to the stock & bond markets. These strategies greatly enhance diversification benefit and potential return opportunities due to the lack of influence by the stock & bond markets on their return streams.
Most bond investments carry interest rate risk because they have a fixed interest rate. There are however opportunities to purchase interest bearing investments where the rate of interest floats up or down, month-to-month, based upon prevailing interest rates. These securities are known as “floating rate investments.” Some examples would include:
- Floating rate loans
- Floating rate notes
- Floating rate preferred stocks
The majority of investors buy these investments through a mutual fund which specializes in floating rate securities. In this environment, with rates at historic lows, floating rates securities could make a nice addition to a diversified portfolio. The risk of seeing one’s income stream diminished due to dropping interest rates is minimal and the upside from here if rates rise (and in turn the investor’s income stream goes up) is substantial.
How do these ideas as well as traditional inflation hedges (stocks & real estate) protect me against inflation?
In order to beat inflation, you must have a return that exceeds the inflation rate. In the investment world, this is called the “real return.” The real return is the return that you earned on an investment after taking inflation into account. For example:
- Nominal Return on investment: 7.00 %
- Inflation: -2.10 %
- Real Return on investment 4.90 %
Real returns are often ignored by many investors, who instead focus on the top line return number. Today’s short term bond fund investments offer a very good example of a positive top line return with a negative real return:
- Short term bond fund yield: .60 %
- Inflation: -2.10 %
- Real Return on investment -1.50 %
With real returns in mind and a goal of beating inflation, let’s take a look at investments that can protect against inflation.
Stock Investments (ETFs, Mutual Funds and Individual Stocks) offer two ways to fight inflation: growth of the share price and growth of the dividend. Many companies are able to pass on the effects of higher inflation to their customers by simply raising prices in an amount equivalent to the inflation. Thus in an inflationary environment, the company’s earnings will rise, allowing the company to increase its dividend amount and at the same time increasing investor demand for the shares will raise the share price. As long as the total return from dividends and share price increases exceeds the inflation rate, the investor is earning a positive real return.
Market Neutral & Merger Arbitrage strategies both have the ability to outpace inflation. Since their return stream is not dependent upon the stock or bond market’s direction, these strategies have the ability to make money under any market situation. So long as their returns exceed inflation, the investor is harnessing a positive real return.
Convertible Arbitrage, Managed Futures & Fund of Funds strategies also have the ability to outpace inflation. While these strategies will be somewhat influenced by the stock & bond market’s returns, they ultimately have a goal of positive real returns.
Real Estate investments offer yet another inflation hedge. Real estate investments have the ability to raise rental rates on the tenant, thereby protecting the investor against inflationary effects. Similar to an increasing dividend on an equity position, the increasing cash flow from a real estate investment can offset the damaging effects of rising inflation.
Why didn’t I mention commodities like oil, or gold?
I don’t see any value in the commodities markets. The bull market for commodities began in 1999 and has likely hit its peak. There may be some upside from here but I think that upside is very limited. The downside risks however are significant and growing. Once again, why buy something with a bad outlook? Just because a computer software program tells you you should? No thanks!
Oil. The oil market may already be in the beginning stages of a long term price decline. Many have forgotten that oil hit $150/barrel in 2008 and 5 years later, at $94/barrel, oil is still 37% lower in price. The big drop in the U.S. dollar relative to other currencies is likely behind us. Dollar strengthening may be the order of the day going forward. A strengthening dollar will bring down both commodity prices in general as well as the price of oil. The fracking revolution taking place in the U.S. and substantially increasing domestic production of oil is another catalyst for declining oil prices. China is the other factor. No country can continue to increase its industrial capacity year-in and year-out without eventually hitting a wall and ending up with a supply overhang. China is on that path. When China stumbles, and stumble China will, the story that everyone has fallen in love with to boost commodity prices for the last decade+ will suddenly have become just that, a story. The corresponding price destruction in the commodity markets will be intense.
Gold was a great idea about 13 years ago. As the dollar declined against other currencies and the U.S. ran into a systemic financial collapse, gold offered certainty to many in very uncertain times. The run for gold has reached the last innings. Improvement in GDP as well as potential rising interest rates (especially if a positive real return is available on money markets or t-bills) will send gold lower. Investors may not mind holding gold now when there is no return available on money markets. But if in the future money markets offer 3 – 5% and some amount of real return, be prepared to see large amounts of capital exit the gold market. My last thought on gold is that it has become another herd type investment. Look at all the commercials out there peddling gold IRAs or gold coins, etc. When all the buyers have gotten on the train and there is no one left to sell to, prices can fall rapidly when everyone tries to get out at once. We may well be close to a major correction in gold.
Ethan S. Braid, CFA
HighPass Asset Management
800 – 672 - 7916
About the author of this article.
Ethan S. Braid, CFA is the founder of HighPass Asset Management – an independent, fee-only, registered investment advisory firm with a fiduciary duty to the clients it serves. Mr. Braid has been passionate about managing client investment portfolios and providing customized financial planning advice since he started working in the investment industry 14 years ago. Mr. Braid earned a BS in Finance from Robert Morris University, an MBA from Cleveland State University and he is also a CFA Charterholder.
Mr. Braid is devoted to being an expert in the field of wealth management for high net worth individuals and families and for many years, has read one book per month on subject areas such as: estate planning, retirement planning, investment analysis, mergers & acquisitions and behavioural finance. Mr Braid also has a passion for business history with a focus on the late 19th & early 20th centuries.
When Mr. Braid is not helping clients, he enjoys: cooking, wine, exercise, his yellow Labrador retriever, fly fishing, hiking, travel, playing guitar, snowboarding and duck hunting. Mr. Braid is a committee member of the Denver Chapter of Ducks Unlimited.
This article is provided by HighPass Asset Management for informational purposes only. No portion of this commentary is to be construed as a solicitation to buy or sell a security or the provision of personalized investment or legal advice.
[i] Morningstar Direct U.S. Open-end Asset Flows Update, March 2013
[ii] Morningstar Direct U.S. Open-end Asset Flows Update, March 2013
[iii] Morningstar Direct U.S. Open-end Asset Flows Update, March 2013
[iv] Federal Reserve Bank of St Louis
[v] Morningstar Direct U.S. Open-end Asset Flows Update, Sept 2012
[vi] Federal Reserve Bank of St Louis