Just What It Means To Be In A Bond Bear Market

 

"Fears are nothing more than a state of mind"

- Napoleon Hill

Perhaps now is the time to start adding duration. The media calls for the end of the bond bull market and even calls for a multi-decade bear market have been extremely loud. Bond investors fear rising interest rates seemingly more than anything else. That fear has been palpable in 2018 with duration underperforming most asset classes.

The move in rates early this year caused a panic in both the bond markets and equity markets. In what could best be described as the first jump in rates since the Taper Tantrum, the event went off poorly for nearly all investors. The arguments for holding longer-duration bonds have been deemed unjustifiable in this "rising rate environment."

One of those arguments rests on the notion that rates fell for 30+ years and must rise to return to "normal." But what many of the bears miss is that interest rates rose for over two decades prior to the start of the bear market.

 

(Source: A Wealth of Common Sense)

That begs the question, what is normal?

For most of the last several hundred years, interest rates have average around 4%. But for most of the last 30 years, interest rates have been higher than that (though falling). Recency bias causes investors to recall the most recent events and extrapolate them as "normal."

We believe given the demographic challenges facing much of the world we are likely closer to the end than the beginning in the rise in interest rates. Despite record treasury issuance and large fiscal deficits, at the same time that the Fed is selling assets from the balance sheet, interest rates have been unable to rise since February. Underlying inflation remains stable though it has inched higher in conjunction with higher oil prices. However, we do think inflation will not rise much more from here unless wages substantially accelerate.

In a low growth environment with still very tepid inflation, a significant rise in yields from here seems improbable. At worst, we see the rise in yields likely to be gradual and ultimately limited.

 

 

10 Year Treasury Rate data by YCharts

 

A risk to that view is the reversal of globalization due to trade tensions and public policy shifts that cause sharply higher prices for goods.

We believe there is over-investment (crowding) in the short end of the high yield bond market. Wholesalers tend to pitch mutual funds to financial advisors where funds are flowing. Short-duration has been the magnet in the bond world so far this year. The selling pitch has been "strong yields with very low interest rate risk."

This has kept high yield bond spreads from widening just as investors have fled investment grade corporates.

High yield:

 

Investment grade:

 

Investment grade bond spreads have widened out to 125 bps, a level they hadn't been at since the start of 2017. The probable reason is the fear of higher rates and the duration of investment grade versus high yield. Given the low yields and the desire for corporations to extend maturities, it is not a mystery why this has been occurring.

Meanwhile, investor demand via fund flows has been pouring into those short duration bonds causing speculative companies to issue more shorter-term paper. This has caused the duration in high yield credit to fall to record lows.

 

We believe we are on the cusp of another change in sentiment with a focus on higher-quality again. Investment grade bonds offer up a solid risk-reward compared to high yield. However, both high yield and investment grade offer little upside potential for additional spread tightening.

Look for an upcoming article on how to play the space from a different angle.

In our recent article titled, "Avoiding Sequence of Returns Risk With Easy Laddered Bond Portfolios" we discussed using cheap bond ETFs for our short-term bucket. Meaning, assets that are slated to be used for spending in the next several years. By placing them in investment grade bonds with bullet maturities, we can avoid interest rate risk and significant default risks.

Today, given the run in the markets over the last decade, and indicators that to us point to being in the latter innings of the cycle, we are making preparations. Those preparations include bolstering our safe bucket so we are not withdrawing from our portfolio during a down market. This is because if you're in an equity-heavy portfolio and are withdrawing during a bear market, you can be digging yourself a large hole from which you likely won't be able to recover. And we think a lot of investors are very equity-heavy today, with dividend stocks and low (and rising) yields in bonds pushing them there.

Our marketplace service is dedicated to helping do-it-yourself investors and advisors (a significant percentage of our membership base are financial advisors) think of their portfolios holistically and not just throw out stock recommendations.

The basis is to match spending each year with income - a no touch of the principal strategy. Cash flow investing at this point in the cycle, after significant capital gains have already been realized, makes sense to us.

By not having to sell when markets fall and instead keeping that money invested to earn approximately 3%, you are not sacrificing a lot of return opportunity cost in order to protect your portfolio. Withdrawing capital in the depths of the recession means that capital is not there to participate in the recovery. That can produce large differences in portfolio values at the terminal year (often the estimated year of death).

The Bottom Line

Investors shouldn't fear rising rates and shun bonds. Most individual investors know very little about bonds but they do know that rising rates negatively effect the price of a traditional bond. What we are seeing is many investors shift their bond assets to cash (earning less than 1%) or to dividend paying stocks. The question is: what are your bonds there for?

If the bond portion of your assets is to provide 'ballast' to the portfolio from stock volatility, than moving to cash will continue to offer some ballast. However, many high quality bonds tend to increase in value during stock market swoons. Cash will not do that so the notion that your bonds "zig" when the market "zags" is not really there by the move.

If the bonds are there for income, than moving to dividend paying stocks will continue to generate income and add growth to that but you are taking substantially more risk. Using typical standard deviations, a high quality dividend stock has approximately 4x the level of volatility compared to a typical investment grade bond.

We think investors who re-allocate from bonds to either cash or stocks at this point in the cycle would quickly underperform compared to sticking to a traditional bond strategy.

The fear of rising rates misses one key aspect. Bond investors tend to benefit from higher rates over the long-term. That is because older lower coupon bonds eventually mature and get replaced with a higher coupon bond.

The current pace of higher rates is well-telegraphed by the Fed without any surprise shocks. But with the yield curve getting very flat, we think the amount of further hikes by the Fed will be less than what the market thinks. With one further hike, the difference between 10-year and 2-year treasuries will be down to zero.

Investment grade bonds look very compelling here and certainly more so than getting into high yield bonds today. Spreads are well off the tights and interest rates appear to be contained. We think investors are crowded into the short-end of the curve, especially into high yield opening them up to high yield spreads widening.

One such idea is Invesco High Income 2024 (IHTA) which is a target term fund that invests primarily in investment grade (BBB-rated) commercial mortgage backed securities. The fund is at an attractive discount and offers the opportunity for high yields (~6%) plus capital gains with a relatively safe pool of holdings.

The bottom line is that the fear of a bond bear market is driving investors into just a small area of the bond market: floating rate, short-duration high yield. Meanwhile, decent value on a risk-reward basis is forming on investment grade and in duration. Remember, if you are looking for bonds to provide ballast to your portfolio, then you want positions that will be durable during a downtown. However, it appears most investors are in credit-sensitive investments searching for high yields