Why Bonds Terrify Me

One of the most common conversations someone will have with their financial advisor is how much do you want in stocks vs bonds?  If you can handle more risk for potentially higher return you’d want more in stocks while if you’re really conservative you’d have a lot in bonds. What’s a bond you ask? Basically a borrower takes out a loan and promises to pay you interest in the form of periodic coupon payments and give you the entire lump sum back when that bond matures. Common maturities on bonds include 5, 10, 20,  and 30 years. If you invest in your 401k, you probably own some and don’t even realize it. If your parents are approaching retirement they probably have close to half of their portfolio sitting in bonds. Because of the events of the last seven years, bonds terrify me. Bonds as an asset class are the most overvalued they’ve been in at least six decades.

I used to be a bond trader for one of the largest money managers in the world so I have gotten to see the risks and what they could mean for your pocketbook firsthand, and in some cases especially if you’re investing in bonds with long maturities you could lose almost as much money in bonds as you could in the stock market and people by and large don’t know this.

How We Got Here: Fed’s Been Pumping ‘Roids Into the Economy The Last Seven Years

How did we get to this point where the Treasury would give you a paltry 3.22% (current longest dated treasury yield as I write this) for locking your money up for 30 years? It’s been a result of some of the most extraordinary monetary policy in our country’s history.

When the stock market was crashing back in 2008 and everyone feared a second Great Depression the Fed took drastic action to avert that result by lowering short term rates to almost zero and announced QE1, aka Quantitative Easing. They tried to pump prime the economy by pouring hundreds of billions into government bonds and agency securities aka the things that help you get mortgages.

After the first QE1, the Fed announced QE2 where they would buy around $600 billion more of long treasuries. Since this didn’t push down long term interest rates enough, they moved into something called Operation Twist, where they basically manipulated the bond market to get lower long term interest rates. The reasoning was if you have a crappy housing market one way to support it is by having low mortgage rates. Also, if bond yields look fugly then you would want to put your money in riskier assets. I went to a talk by one of the top officials at the Atlanta Fed once and he basically advocated for grandmas to sell their bonds and buy dividend stocks instead despite the risks.

In doing all this funny business the Fed hoped to make saving less attractive so people would keep spending money. They wanted to support risk assets like the stock market by making their substitutes, bonds, less attractive and thus people would move money into stocks and support the economy through the wealth effect, that people spend more when they feel richer. They also wanted housing values to stay elevated rather than find a true bottom to avoid more mass foreclosures and encourage job mobility by helping people to be able to sell their house without taking a big loss.

After they got done with all this historic stimulus, they decided you can never have too much of a good thing, so they announced QE3 where they would buy about 40 something billion USD each a month in mortgage backed securities and long term treasuries. I was on a trading desk when Bernanke came out and said they would be “tapering” the purchases of these securities and when he announced that the bond market flipped out and sold off a ton at the end of 2013 / beginning of 2014. The Fed really didn’t want that to happen, so the new regime under Yellen had to talk everyone off a ledge about how monetary policy was still super stimulative and so you should keep buying bonds with terrible interest rates.

The Fed had to maintain credibility and wind down their asset purchase program from QE3, but they still are the biggest X factor in the bond markets, holding trillions of dollars on their balance sheet in fixed income instruments. This is how we have come to the point of a bond market with a healthy economy with such extreme overvaluation.

Bonds Terrify Me, and They Should Terrify You Too. See What You Could Lose in Bonds

The bond markets are unpredictable and I could look like a fool for writing all this as at the end of the day it’s all about where interest rates are at how much bonds are worth. However, bonds are a lot more logical than stocks in that it’s about the math. If you show me a share of Tesla I have no idea what it’s really intrinsically worth. The market has an idea based on future earnings growth it should be worth X, but who knows really there’s a ton of speculation and gambling there. With bonds, your price change is based on something called duration. For a 30 year treasury bond, I did some back of the napkin math and came up with a duration of about 19. This means that if interest rates go up 1% right now, your bond would lose 19% in value. Duration is a metric people in the bond world use to figure out if you’re getting paid for the risk you’re taking. Usually large coupon payments help soften the blow of straight up price change in your bond, but when you’re getting paid 3.22%, that’s nothing. It hardly protects you against a price change at all.

Since back at the turn of the century in January 2000, long treasury bonds could be bought at north of 6% yields, it’s not at all unreasonable to think after the economy improves for a couple years you could see some inflation. Since investors require a real yield for owning long treasury bonds you could feasibly see that debt go back to yielding more than 5%. With today’s duration statistic on the 30 year bond, you could lose almost 40% on that investment. If it happens gradually, which is far more likely, then you could still be stuck with large 20%+ losses.

If you own shorter maturities you have less to lose because the duration is lower. I think if you’re going to own bonds it makes the most sense to do so where you get the most yield per unit of duration which is in the intermediate range on the yield curve (think like 7-20 years kind of thing with an average maturity of 10). You can still lose a ton of money there but it will be far less than if you’re piling into long treasury bonds. Because these long bonds have been the best performers lately, you better watch out if you’re performance chasing and putting money in what has done best lately. There has been virtually no risk in the bond markets the last 20 years, making today extremely dangerous for the sleepy retiree thinking their money is safe.

How the Fed’s Bond Manipulation Has Made Stocks Less Safe

Another danger is what low yields have done to the stock market. Since the Fed has pushed people into risk assets because conservative ones aren’t returning anything, the P/E ratio, a common measure of how over or undervalued the stock market is, is around 20. The long term average is something like 15, meaning that investors are paying about a 30% premium over what they have long term for owning the stock market right now. This premium could evaporate when bonds normalize, making losses of that magnitude not out of the question.  Tech companies like Instagram, Whatsapp, and Snapchat getting billion dollar valuations without substantial earnings harkens back to the Pets.com era during the tech bubble.

If and when interest rates go higher, expect these kind of companies to get walloped. If you’re going to have money in stocks I’d rather put it in conservatively valued companies, like 15 times earnings or less with stable balance sheets and decent but not salivating prospects. They will still go down in value but at least their cash flows are worth something unlike these social media darlings that will become worthless if something else comes along.  So basically, don’t have a ton of money in the Teslas, Facebooks, Twitters, etc. of the world unless you’re ready to lose a lot of money.

Practical Portfolio Ideas

The large money manager I used to work for once ran a simulation for the optimal portfolio and bond exposure was way reduced and replaced with a lot of cash. They ignored that finding and stayed with the same allocations they always tout because they have billions of assets in bond funds, which would be a massive revenue loss for them if people pull the money. The advice you’re going to hear from the big companies is not to change anything, which seems self interested to me. If you’re going to own bonds, own a diversified basket. Own some short term TIPS, which move positively with expected short term inflation. Have some investment grade corporate debt to give yourself extra cushion against interest rates. Also, a core holding like a Total Bond Index Fund from Vanguard makes some sense because it’s duration is shorter, like a 5.7, so you can’t lose as much but pair it with some cash in case bonds get significantly more attractive so you can leg into it with a better average cost. If you own any debt, pay that off before buying bonds. I had a buddy once with 6% student loans with $10,000 in a bond ETF yielding 2%. He was paying 4% a year for that mistake so get rid of any debt first before you even think of putting money in bonds.

Be well diversified. Don’t keep your eggs in one basket. Since bonds suck if you’re under 30 I’d ignore typical advice and hold 0% in bonds because there’s no reward and very little risk protection. I’d split your money between having a rock solid bucket of cash to cover a few years of expenses and the rest in stocks. As far as your earning power, aka human capital, make sure your labor skill is not in the same sector as your portfolio, IE don’t be a programmer with a portfolio all in tech names. You could be jobless AND broke at the same time. Any cash compensation that you invest should be in boring value companies to provide you protection if that industry blows up. You might have tech stock options which you have to account for when you’re building your portfolio, so a typical index fund might now make sense for you. If you own a house in the Valley or other tech hub you could be triple exposed, which if you have been then you are probably doing really well, so get out while you still can.

Parting Thoughts

When the Fed takes all this stimulant off, no one knows what will happen. The last two times they helped cause the tech bubble and then the housing bubble in large part due to monetary policy. So save a lot, be balanced in your portfolio, and don’t get excited by investing fads like long term treasuries or social media stocks.

If you don’t believe me that bonds are horrible right now, especially those beyond 10 years in final maturity, let me quote from a famous investor’s letter to shareholders in 1984 where the author was speaking about another time in history when interest rates were this low, the 1940s.

Our approach to bond investment - treating it as an unusual 
sort of “business” with special advantages and disadvantages - 
may strike you as a bit quirky.  However, we believe that many 
staggering errors by investors could have been avoided if they 
had viewed bond investment with a businessman’s perspective.  For 
example, in 1946, 20-year AAA tax-exempt bonds traded at slightly 
below a 1% yield.  In effect, the buyer of those bonds at that 
time bought a “business” that earned about 1% on “book value” 
(and that, moreover, could never earn a dime more than 1% on 
book), and paid 100 cents on the dollar for that abominable 
business.

     If an investor had been business-minded enough to think in 
those terms - and that was the precise reality of the bargain 
struck - he would have laughed at the proposition and walked 
away. 

- Warren Buffett

Bonds aren’t as bad as they were then, but with the taxable treasury curve in 20 years closing in on 3% with a “bond P/E ratio” higher than 30, which is higher than it is for the stock market, I’d do some laughing and walk away from bonds at their current prices.