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Bond, Treasury Bond

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Over the past 30 years, the policy of our Federal Reserve has been to lower interest rates as the risk of inflation has decreased. Many of us with a wee bit of gray at our temples remember Paul Volker raising rates to combat the 1970’s inflation that stemmed from wrong-headed fiscal and monetary policy decisions made by governments starting after Kennedy and ending before Reagan – Ford gets a big pass because he (a) wasn’t there long enough to make an impact either way; (b) kept our country from falling into a third-world style vendetta of revenge against Nixon (much the same can be said for Mandela and his policies in the aftermath of the Afrikaners – what ever happened to classy guys like those running countries? The world is sorely in need of that at the moment); and (c) came up with the nifty Whip Inflation Now slogan and its ubiquitous WIN buttons. But, I digress…

Those rate cuts brought on a secular bond bull market that you can see on the chart above that traded in a consistent upward bound range from 1982 to present.

There is a lot of talk that the bull market ended last summer (you can see that the high point on the chart was mid 2012 and since that time the bond market has been moving from the top of that 30-year range to the bottom of it). Their basis for this is that bond yields hit their lowest levels several months ago and Europe is recovering (so the rush to safety trade is past).

I can buy into this theory, but given that we are still within the trading range – and until we fall below the bottom blue line – we can’t state for a certainty that the bull market is over. Over the past 30 years, this trading range has held and the bond market has moved up and down within the range as macro forces impacted it.

The biggest impact on bond prices is the change in interest rates. This is investment management 101 – rates up mean prices down. So, the chart below shows that move in interest rates.

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When you look at this chart, you see where rates bottomed last summer, as the theorists who believe the bull market is done have stated. You can also see that rates skyrocketed in May when investors heard the Federal Reserve Chairman state that their bond buying/money printing was on borrowed time.

But, interest rates generally move in relation to inflation. Check out this chart (its from Google images – I didn’t create it but can provide a source for it, either – if you created it, this blog thanks you!):

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You can see that as inflation has moved down over the years interest rates have also moved down in a similar pattern. But, the move higher in rates since last summer has not been due to increases in inflation, but rather something else is going on – bond investors’ assessment of the risk to their principal from investing in Treasury Bonds.

The chart below shows you the performance of intermediate US Treasury Bonds to Junk Bonds (as represented by two applicable mutual funds) since the Fed adopted their policy of buying treasury bonds. Its pretty tough to infer that junk bonds are more risky than treasury bonds from this chart – in fact, junk bonds (the red line) looks less volatile and held their value far better than treasury bonds (the dark blue line) in the period since rates started rising.

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The Fed’s stated policy has been to increase the value of “risk” assets in order to provide a wealth effect and make consumers spend/consume more as a strategy to kick our economy into higher gear. Asset values have gone up, but the economy is limping along at a roughly 1.4% GDP growth rate for the first half of the year.

Unfortunately, what this policy is doing is driving investors out of safe assets, like certificates of deposit, treasury notes, and high quality corporate bonds (which are yielding very little) into the stock market and into junk bonds (and other esoteric investments that they don’t understand) which yield more. This is a really bad thing, but they are looking at the risk as being the same between the safe investments and the extremely risky ones so why not go for the risky ones with the higher yield.

But check this out:

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This is the same graph comparing intermediate treasuries to junk bonds, except over a 20 year time frame. When you expand the data set, you can clearly see that junk bonds are called junk for a reason – there are periods of significant loss on that red line that would devastate most investors who are really savers and inherently risk averse. Unfortunately, the Fed’s actions are manipulating the bond market (and the stock market but that’s a discussion for another time) and in particular the riskiest part of the bond market, to appear less risky than it truly is.

What these investors will find is that the money they rely on to support their lives will be gone – potentially gone for a long time if they are in unhedged mutual funds or more esoteric investments – when we move from a secular bond bull market to a secular bond bear market.

There is a fundamental difference between owning a mutual fund with no maturity date and a corporate bond with a fixed maturity. If you own an intermediate term bond mutual fund and interest rates go up, your fund (if unhedged) will go down. And since there is no maturity date on the fund, it can stay down for years as the underlying assets grind on until they mature (if the fund manager holds them until that time) – not something most investors understand.

Individual corporate bonds, on the other hand have a fixed maturity date. If you buy a two or three year IBM bond and pay $5000 for it, at maturity you get your $5000 back to reinvest – and if you are in a rising rate time period, you get to reinvest all of your money back into a new bond at the higher rate. Its a pretty good deal and the best strategy a fixed income investor can adopt in a bond bear market.

So, in keeping with our standard risk management practices, we have begun to move out of the diversified fixed income mutual fund portfolio we have used for several years, into a portfolio that is structured as follows:

1. If the fixed income portion of a portfolio is large enough to justify owning individual bonds, we take roughly 1/2 the portfolio and build a maturity ladder of high quality corporate bonds with fixed maturities between one and five years. This way, as interest rates rise, we are able to reinvest the bond proceeds at ever-higher rates as we move through the potential bond bear market.

[the strange thing is that we could have the first bond bear market in our history that does not involve rising inflation, but have rising interest rates due to bond investors fear that all of the accumulating debt our government is taking on makes their credit worthiness less than it should be]

2. Of the remaining 1/2 (or if the portfolio is too small for individual bonds, then the entire fixed income allocation) is shifted to favor adjustable rate bonds (split 40% to adjustable rage corporate securities and 60% to adjustable rate AAA government securities) with the balance of the mutual fund exposure in short term/duration bonds and slightly longer duration hedged bond funds.

In a falling rate environment, mutual funds that have a longer duration than you would use when owning individual bonds, tend to provide you with capital appreciation and higher income. Unfortunately, in a rising rate environment, you experience capital loss that tends to exceed your income. Knowing and understanding this simple fact is one of the tricks of the trade – every investment has its time and place. The time for bond funds potentially has passed and the time for individual bonds appears to have arrived.

I started my career at the tail end of the last bond bear market – I remember the 14% 30-year treasury bond and wish that more people had dropped their entire investment portfolio into them. But, most people in the investment business now are younger than me and only know the bond bull market. Most can’t imagine a 14% treasury bond let alone a bond fund with capital losses – things are going to be very interesting, and expensive, for many people who should own CD’s and not some closed-end junk bond fund (with a user-friendly name like High Income Fund).

It will be interesting to see if all of these people that are being advised by their investment managers to buy the risky investments (those that will be hurt the most by rising rates) will surrender to the bear and work to them out of it before the worst of the damage is done or if they will ride them much much lower. Its an academic question, and one that might seem more than a little bit weird, but answers to questions like these provide patterns of human behavior that help guide future decisions for investment professionals.

Anyway, have a good night.


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Mark