Archive for February, 2017

Bonds Are Boring? Hardly

Friday, February 3rd, 2017

10 yr

Double click any graph for a larger view

With bond yields on the rise, the investment landscape has change quite a bit.  Last July marked a low spot in bond yields with the 10-year Treasury Note hitting a 1.34% yield.  You can see that low on the chart above and the subsequent steady move higher until the November election.  The move higher in yields after the election was the fastest move in yields that I have ever seen.

At that time, bond investors believed that the new administration would institute pro growth policies that would move the sluggish sub 2% GDP growth we currently have to between and 3% and 4% GDP growth.  That sort of growth is typically inflationary so investors were moving yields higher in anticipation of higher inflation.  However, you can see that since early December, investors have begun to waiver in that belief and yields have come down a bit.  However, now that the Congress is behind tax reform and regulatory reform, growth could very well pick up and yields could embark on another move higher.

If we are in fact moving into a period of sustained moves higher in rates, this could be the end of the 30+ year bond bull market that has taken yields on the 10-year from just shy of 16% to today’s 2.5%.  You can see this move in the graph below.

Screen Shot 2017-02-03 at 2.02.14 PM

The graph above gives you a long-term historic perspective.  But lets focus on the graph below that I have annotated with a red trend line that follows yields as they have fallen over the years:

10 yr bull 30 yr

The thing that bothers me is that yields have broken above the down trend line – IF this means the bull market is over, then from a purely technical perspective we could see a move to 5%.  You can see the blue line I have drawn at the double top in yields on the left side of the blue line.  The double top is a strong technical level that will act as resistance if yields approach 5%.

The real question is, from a fundamental perspective, would the economy support that level of yields?  It really wasn’t that long ago that we had 5% yields – in fact it was just prior to the Great Recession that started in 2009, commensurate with the subprime crisis.  If you were to look at GDP growth at that time, it was in that 3% to 4% range.

This is not a prediction that we are headed to 5% yields, but rather a recognition that it is possible if the new administration’s policies do in fact spur GDP growth (that is no sure thing – lots of variables enter into it).

So, for prudence sake, I want to give you some perspective on what we are doing in the face of rising yields relative to our clients’ portfolios that have an allocation to bonds.

Someone told me long ago that individual bonds are preferable in a rising yield environment.  However, bond mutual funds and closed-end bond funds (bought at a discount to NAV) are preferable in falling yield environments.  Below is some of the logic that we employ when making decisions in managing a bond portfolio.

  • Investors do not understand that they can lose money in bonds – they view them much like CD’s where a dollar in is a dollar out, plus the earned interest.
  • With a bond fund in a rising rate environment, the loss that they see on the principal of their investment can equate to multiple years interest earned, depending upon the credit rating and duration of the bonds in the fund.
  • Providing clients a portfolio of individual bonds, A rated or higher (whether taxable or tax exempt, subject to the needs of said client), allows us to structure a portfolio that has frequent cash flow for reinvestment as yields move higher and as the bonds mature at face value.
  • Even if there is some market value fluctuation, everyone knows that it is temporary, as they see those market values move to par at maturity.  You do not have this with a bond mutual fund where there is no maturity date for the bonds to reach.
  • When building a portfolio for clients, it is imperative to be sure that your positions are fully diversified with no concentrations in companies, industries or sectors.   I’ve seen several investment managers not take the same diversification precautions with individual bond portfolios that they do with equity investments.  In 2008, several managers had a significant overweight in financial industry bonds.  They were lured into them as the banks, brokerages and insurance companies were paying much higher interest rates on their bonds than similar maturity and rated non-financial industry bonds.  Their clients suffered significant and irreparable losses when Bear Stearns and Lehman Brothers collapsed.
  • Mortgage backed amortizing bonds, like GNMA’s, which are great for larger institutional clients because of their constant cash flow, are absolutely not right for individual clients.  The accounting for the principal and the interest is too complex and many individual clients view the entire P & I payment as income that they can spend – not a desirable outcome if they need to reinvest the principal for future income purposes.
  • In a falling rate environment, closed-end bond funds bought at a discount can be extremely profitable.  In the past, we have purchased both taxable and tax exempt closed end bond funds at 8% – 10% discount to NAV, collected the income, and held them until they reached a roughly 5% premium to NAV.  We easily made over double digit returns on this strategy without undue risk (we stick to investment grade corporates, governments, or muni’s).
  • Bond mutual funds also work very well in a falling rate environment.  You can purchase a fund with a long duration that will maximize your capital appreciation as yields fall and you collect the income stream as you wait.
  • If you were to have a portfolio individual bonds of similar duration as the bond funds, investors can be confused by the lengthy maturity date far into the future.  You therefore end up constructing the portfolio with shorter-dated bonds and therefore abdicating the larger capital gains that comprise a large part of long-term strategy in bond portfolio management.

One last thing I wanted to point out is bonds can have a place in an all equity portfolio as well.  There is a strategy that we utilize when a stock market correction runs its course –  we invest in high yield bond mutual funds.   The capital gains you realize from the high yield bonds as the stock market recovers are even larger than those from the stock market itself.  The high yield bonds are a higher beta way to capitalize upon the recovery with a portion of your equity portfolio – but we never allocate more than 5% of an equity portfolio to high yield – it just would not be prudent.  Check out the graph below:


This is a graph  of the S&P 500 Index showing the 2008-2009 stock market crash and recover in red and high yield bonds in blue.  You can see that the high yield strategy provides higher returns during the recovery part of the stock market cycle and then they revert to an equity level return as the recovery runs its course.