Bonds: Investment Outlook, June 2016

As mentioned in yesterday’s investment outlook, bonds are perhaps more expensive than stocks right now. Stocks have only been as expensive as they are right now three times in recordable US history. Bonds, on the other hand, have never been as expensive as they are now!

Sometimes it can be confusing to think of bonds as being overvalued or undervalued because bonds are supposed to be ultra-stable, only-go-up-in-value investments, right? Actually, no. Bonds have been on the longest bull run of any investment – for 33 years now. Therefore, most of us either weren’t around or can’t remember when bonds lost money from year to year.

What determines the price of bonds? For the high credit quality bonds that I recommend, interest rates cause 95% of price fluctuations.

Let’s look at an example: the year is 1980, and you happily purchase a ten year treasury bond yielding 10% per year. Two years later, you’re not so happy. In 1982, the going yield for treasuries becomes 15% per year, and you are locked into receiving 10% on your treasury bond. Because your bond pays less in comparison to shiny, new bonds, the price of your bond plummets. Whereas you probably bought your bond at par value ($1,000), you could now only sell it for around $700.

Sure, you could hold onto the bond until it matures in eight more years. That would mean that you would get back your full $1,000. But in the mean time, it can be very scary to see a United States Treasury Bond, supposedly the safest investment in the world, lose 30% in value. Not only that, the inflation rate in the US reached 15% around 1982. This means that after inflation, you were gaining a 10% yield on your treasury bond but losing 15% to inflation. Over two years, that’s a total of a 40% loss. You lost 30% on the value of your bond plus two years of -5% real returns due to inflation.

Real return = return you see – inflation.

Check out this historical yield chart. It shows you how much ten year treasuries yielded historically.

Screen Shot 2016-06-18 at 8.01.27 AM

(Source: http://www.multpl.com/10-year-treasury-rate)

So we learned that the price of bonds moves opposite of interest rates and that inflation can result in negative real returns. These are two major problems for today’s market.

First, as you can see in the chart, today’s ten year treasuries yield only 1.6% – they have never yielded this little. If the price of bonds moves opposite of interest rates, and interest rates can only fall 1.6% before they’re 0%, there isn’t much room left for prices to rise.

Second, inflation could come roaring back at any time. Because of the 2008 crash, the Federal Reserve TRIPLED the number of dollars in circulation. Historically, inflation follows the increase in the amount of money in circulation, although it may take a while to surface. We haven’t seen it yet. Inflation has been near zero. It’s out there, but it hasn’t surfaced. If you buy a treasury bond yielding 1.6% and we have a minor inflation scare of 5% inflation per year, you’re losing 3.4% per year. And that’s assuming a minor scare and not something much larger.

Could yields fall further and rise in price? Absolutely. Ten year government bonds of European countries and Japan have fallen into negative interest rates! That means that you can hand over your money to the government for ten years, and you have to pay the government interest, not the other way around. It sounds crazy, and it is. It’s absolutely ridiculous, and it has never happened before. I don’t think it will end well.

Going forward, there are three possible scenarios for bonds:

Scenario 1: On average, the economy enters a recession every six years. It has been eight years since our last recession. If the economy enters a recession, US treasury yields will fall even further, perhaps reaching negative rates just like European bonds. This would result in your bonds making money.

Scenario 2: We could enter another period of “stagflation” which stands for stagnant economy, high inflation. Stagflation describes the period in the late 1970’s and early 1980’s we talked about above. This would certainly not be good for your bonds. Inflation and interest rates would skyrocket, and your bonds would lose a lot of value.

Scenario 3: The economy does great, and interest rates rise, causing the value of your bonds to fall.

I would give scenario one a 45% chance of happening, scenario two a 45% chance of happening, and scenario three a 10% chance of happening.

Bonds are certainly not a sure bet. If you do buy them, stick to high quality, short to intermediate term (1 to 5 year) municipal or treasury bonds. In particular, TIPS bonds offer the best value right now. TIPS stands for Treasury Inflation Protected Securities. They offer basically no cash flow, but their price rises along with inflation! So if inflation is 5%, you will earn 5%. Not amazing, but at least you wouldn’t have lost money.

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