INVESTING WITH CLARITY™ BLOG

Why Bonds May Not Be Safe Investments Today

June 13, 2013 4:42:00 PM

The dumbest investment is a long-term bond. - Warren Buffet, March 4th, 2013

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Oftentimes, in the world of modern media and investing, quotes can be exaggerated or taken out of context.

In the case of the Warren Buffett quote above (which I actually heard him say in person), I would argue that one must understand the context in which this bold statement is being stated to fully appreciate its true meaning. Of course, many successful investors own long-term bonds in their portfolios. Additionally, in many cases, owning long-term bonds makes good financial sense.

However, for the purposes of this article, I want to focus on the connection between owning bonds of any sort and the need for Clarity in one's portfolio. It's a discussion on the importance of understanding why an investor either owns or should own bonds in the first place.

First, for disclosure purposes and to set the record straight, I am NOT advocating that investors abandon bonds from their portfolios! What I am advocating is the idea that investors must fully understand the short-term and long-term benefits and risks of owning bonds.

By the way, when I say risk, I don't mean just the loss of principle. One must also consider the risks in buying power (inflation risk), liquidity risks (not being able to sell the bonds because their value has gone down to a level you don't want to sell at and consequently take the loss) and time value of money risks, among others.

If there are those who have not yet realized it, the 31-year Secular Bond Bull Market that began in 1981 has more than likely come to an end.

With the recent intra-day high of 2.21% on the 10-year US Treasury Bond, it had moved 53% from its record low of 1.44% in May of 2012.

The chart below shows how investors have earned equity-like returns in bonds over the last 31 years: an annualized return of 8.6% to be precise. That is 8.6% per year (on average) every year for 31 years with what some would argue is an investment which carries only half the risk of equities.

Like any good thing, in time, this too must come to an end. I believe, that time is now!

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In the chart above, developed by AllianceBernstein, it demonstrates how one can slice-and-dice the bond market into secular or long-term bull and bear markets going back over the last 60 years or so.

Unlike secular stock market runs which on average move in 17-year increments, bond bull and bear market cycles average nearly 32 years in length or approximately twice as long as secular stock market runs.

It has been said that when a stock market moves from a bull to a bear market, it mimics the path of an elevator. When the bond market moves from a bull to a bear market it mimics the path of a set of stairs. We agree with the work done by AllianceBernstein, but would add that based on history, the end of the Bond Bear Market would be closer to the year 2045 than 2030.

Michael Hartnett, Bank of America's Chief Global Equity Strategist, recently published a report titled, The Longest Pictures. It includes tons of charts with some of the most obscure data out there, mostly sourced from Global Financial Data.

One interesting chart that everyone should be able to understand is that of the 10-year Treasury note yield. Hartnett notes that since 1902, Treasuries have followed distinct long-term bull and bear markets. From his report we see the following:

 

  • 1790-1902: erratic yield fluctuations and then a sustained decline in yields to below 3%.
  • 1902-1920: the First Bear Bond Market, yields rise from 3% to 5-6%.
  • 1920-1946: the Great Bull Bond Market, yields go from 5-6% to below 2%.
  • 1946-1981: the Second Bear Bond Market, yields go from 2% to 15%.
  • 1981-today: Greatest Bull Bond Market, yields from 15% to 1.5% in 2012.

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As measured at year-end 2012, the U.S. bond market has been bigger than the U.S. stock market in 24 of the last 25 years. The exception was 1999, when stocks were rather pricey.

On average, the bond market has been 79% larger than the stock market over the last 25 years. At the end of 2012, the bond market was 104% larger. And where has the bond market grown? It has grown, as the chart below states, mostly within the U.S. Treasury Markets. Like any good bubble, whether it was the NASDAQ of 2000, the Nikkei 225 of 1989, Gold in 1980 or Real Estate in 2007, they all end ugly and with a loud burst. Look for the U.S. Treasury Longer-term Bonds to quite possibly be the next big bubble that bursts.

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I believe investors will be required to make a major mental shift away from how bonds have performed over the last 30+ years. For the last three decades bonds provided the following:

  • Equity-like total returns with one-third the risk
  • Price appreciation with a healthy coupon
  • Buffer to the stock market and its volatility

I also believe investors should brace themselves for the following bond performance to potentially occur:

  • Cash-like returns with as much risk as stocks
  • Price depreciation with a nominal coupon
  • Very little buffer to the stock market
  • Bonds as a portfolio diversifier and an income producer at best

Many investors may become frustrated at this thesis, but I believe investors must set realistic expectations for what may likely be (if history has anything to say about) several decades of very modest performance at best.

Lastly, because we believe investors will become more and more frustrated with bond returns for the foreseeable future, we believe more and more investors will once again fall in love with equities.

Invest With Clarity!

 


Mark Pearson

Mark Pearson

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