"Game Over" (for bonds) - Jonathan Clements

[OldShooter]

Well, the answer of course is that nobody knows.

... Cash in the form of Tbills has also historically been a surprisingly good hedge. ... If one was wise enough to buy [TIPS] back when their coupons offered a positive return sure, but now? ...

I'm not so sure about bills. It may be like being nibbled to death by ants. By definition they are short term, so inflation won't take a big bite out of any one, but the long term is just a bunch of short terms stacked together. So a lot of little bites stacked together, no?

Re TIPS coupons offering a positive return, I have mentioned this before but many people seem to miss the subtle point that there isn't really a "coupon" return on the original investment. The coupon rate is applied to the current, inflation-adjusted, value of the TIPS every six months. So for example, using the Fed's 2% rate for 20 years, the security will be "worth" 150% of face value at the end and the "coupon" will be paying 150% of the nominal coupon rate.

A TIPS YTM rate you get with the usual calculations is really only a lower bound, implicitly assuming no inflation. I am too lazy to do a lot of calculations on present TIPS prices because that's really not where I am focused. I accept that if inflation stays low the TIPS we have will probably not have beaten straight govvies but that is not the point. When we bought in the winter of 2006/7 (2s of 2026) it was because we determined that high inflation (like 1980 +/-) was the major threat to our retirement. So we bought the inflation insurance without worrying too much about the premium cost over govvies.

 

[Markola]

My take is that globally-diversified equities are the most important inflation hedge.

And VTIAX international index fund yields 2.51% at present and with a lower P/E multiple vs. VTSAX’ 1.68%.


https://www.morningstar.com/funds/xnas/vtiax/quote

 

[kevink]

Well, the answer of course is that nobody knows. I'm not so sure about bills. It may be like being nibbled to death by ants. By definition they are short term, so inflation won't take a big bite out of any one, but the long term is just a bunch of short terms stacked together. So a lot of little bites stacked together, no?

Re TIPS coupons offering a positive return, I have mentioned this before but many people seem to miss the subtle point that there isn't really a "coupon" return on the original investment. The coupon rate is applied to the current, inflation-adjusted, value of the TIPS every six months. So for example, using the Fed's 2% rate for 20 years, the security will be "worth" 150% of face value at the end and the "coupon" will be paying 150% of the nominal coupon rate.

A TIPS YTM rate you get with the usual calculations is really only a lower bound, implicitly assuming no inflation. I am too lazy to do a lot of calculations on present TIPS prices because that's really not where I am focused. I accept that if inflation stays low the TIPS we have will probably not have beaten straight govvies but that is not the point. When we bought in the winter of 2006/7 (2s of 2026) it was because we determined that high inflation (like 1980 +/-) was the major threat to our retirement. So we bought the inflation insurance without worrying too much about the premium cost over govvies.

Excellent explanation of the complexities of TIPS. You were certainly prescient to buy them when you did.

Regarding cash, this piece from Portfolio Charts is the best I've found for explaining how it can be part of one's inflation-hedging assets, as well as serving other vitally important functions. I think it's especially worth revisiting in light of the Clements article and other pieces that are essentially saying the only bonds worth holding now are Treasuries of such short duration that they're close to being cash anyway.

https://portfoliocharts.com/2017/05/12/understanding-cash-will-make-you-a-better-and-happier-investor/

 

[OldShooter]

Excellent explanation of the complexities of TIPS. You were certainly prescient to buy them when you did. ...

Thanks, but nope. Just lucky. Beginning in 2010 they started to climb in value, reaching about 150% of our cost by 2012. Even now with less than 6 years left they are close to 150% as inflation has grown the underlying value, offsetting the YTM factor. All pure luck.

" prescient: ... having knowledge of things or events before they exist or happen; having foresight ..."

I think that being prescient in the investment context is planning a diversified portfolio knowing that the future will be largely random. That's more or less what Clements is about.

 

[Montecfo]

One reason I don’t worry about bonds is that I have owned the bulk of my fixed income for over 20 years. It has appreciated as interest rates dropped, it occasionally drops as interest rates rise. I rebalance, buying more when down or after a strong equity year. A year after bonds have been “clobbered”, and compared to stocks it’s a mild clobbering, they tend to recover strongly. Interest rates jump around so much and so unpredictability that rebalancing seems the best management tool.

I understand someone looking to buy into bonds today, it perhaps looks a little bleak as they are highly valued. But it doesn’t mean you should sell bonds you already own and buy IMO riskier also fully valued stocks. John Clements agrees that stocks are riskier.

We are simply in another extreme QE environment where the Fed funds rate is pushed to zero and the Fed is buying bonds to boost market liquidity, and as a result there has been asset inflation in both stocks and bonds as investors take advantage.

I just keep rebalancing.

Stocks are riskier, but far more rewarding. Trouble with bonds here is that there is essentially no upside, but downside is massive.

 

[Montecfo]

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

I also went heavily into these. Some have started to mature this year. Best thing I did is go out 6 years on a large tranche of 3.5 percent CDs. Now of course I wish I had even more of those.

My bond holdings are mainly corporates and short to midterm. That's where the cash will go as they mature as well as into selected REITS and preferreds.

I do not rely on my cash/bond portfolio for income but I do require a reasonable return.

 

[foxfirev5]

While I don't rely on my bond funds and cds for income i do realize that in the long run it is the interest paid that determines total return. Both my bond funds and CD ladders show significant market value gains. However I'm seeing a steady decline in interest which will eventually negate the gains. On the bright side I don't feel like I'm missing out by letting my cash pile grow. Maybe I'll even get to spend some in the next year or so.☺

 

[ychuck46]

Not Likely

Boy, that article makes me feel really good about gourging out on 3.0%-3.5% 4-5 year CDs in 2019 (40% of portfolio). I just hope that things normalize before they mature in 2023-2024.

If by normalizing you mean higher rates, that likelihood is not high. The world's economies have become addicted to artificially low rates to spur spending. With the major economies needing to recover from the losses incurred from the foolish shutdowns of whole nations, it will take years of continually low rates to help right the ship.

 

[RobbieB]

Yeah. Normalize? What is normal? This is the new normal.

We're all gonna be wearing masks and social distancing for a long long time me thinks.

 

[NW-Bound]

The money you get from selling options isn't income, it is investment profits.

If the IRS calls it income and taxes it as income, and I can use it to buy bread as I do with income...

Well, I will just call it money. I love money.

And today being the 3rd Friday of the month, a bunch of put options just expired worthless, and I got to keep my money, plus the put option premium.

On the other side of the option coin, a bunch of covered calls will get exercised because the shares went crazily high just in this week, and I am forced to sell them for less than today's price.

That's all right. This happens many times before. People do not go broke for selling high.

I suspect that people who get these shares will be sorry next week when the share prices drop back to where I think they should be. Next week, I will be selling puts to buy them back at lower prices than I sold.

 

[2177V]

The elephant in the room is inflation and high government debt. The federal government is currently spending trillions to prop up the economy and the USA is expected to be one of the top 10 countries with the highest debt/GDP ratio which includes Japan, Greece, Venezuela.

Venezuela has hyper-inflation while Japan and Greece has austerity programs and the economy of both Japan and Greece is not expanding. Unless the next administration raises taxes we will have either inflation or austerity programs to cut back on government spending but this will lead to a stagnant economy.

One reason why the US stock market is going up is because Japan and Europe has negative interest rates which means foreign investors rather invest in the US stock market than Japan and Europe. The Fed wants to increase inflation because inflation benefits the US debt since inflation translate to increased wages which in turn increases taxes. This also means a $1M portfolio will lose relative value unless the portfolio's return is more that inflation. Investing in both bonds and equities will be more difficult than in the past.

There is no easy solution. However, if the economy turns south in 2021 or 2022 and the price of real estate crashes due to high unemployment, I intend to buy low price real estate as a hedge against inflation. You get rental income since people still have to have a house to live in. When the economy recovers and we have low unemployment, the price of real estate is expected to rise. I was a former landlord so I know how to manage rental property. If the income from rental property covers inflation, then that is all I need. This is because I had purchased houses for $250K after the 2008 crash and they are now worth $500K. I only suggest monitoring the price of real estate in your area since real estate can be an alternative to bonds and equities.

 

[tenant13]

I'm betting on another market crash followed by Fed panicking and going negative on the rates. Given that they have no other place to go but below zero and the fact that market and politicians are addicted to Fed's intervention, it's not unlikely. All we need is a failed vaccine and we're in the dumpster. And that's the only reason I hold on to some LT US treasuries. Otherwise I'd buy more Chinese government bonds.

 

[lsimpson33]

I feel like I'm missing something major here, the Fidelity Total Market Bond Fund is up 7.04% and 10 year is 3.60%, far and above what the article mentions?

https://fundresearch.fidelity.com/mutual-funds/summary/316146356

 

[audreyh1]

I feel like I'm missing something major here, the Fidelity Total Market Bond Fund is up 7.04% and 10 year is 3.60%, far and above what the article mentions?

https://fundresearch.fidelity.com/mutual-funds/summary/316146356

That’s past performance - no future guarantees. If you ALREADY owned bond funds, you did very well this year due to the sudden drop in rates. But that will not be repeated, unless rates go negative.....

Also, Total Bond Fund holds a lot of corporate debt, whereas Clements was focusing on treasuries.

 

[dixter]

That’s past performance - no future guarantees. If you ALREADY owned bond funds, you did very well this year due to the sudden drop in rates. But that will not be repeated, unless rates go negative.....

Also, Total Bond Fund holds a lot of corporate debt, whereas Clements was focusing on treasuries.

Simple... the Bond managers will just supplement low yld bond issues for high yld bond issues and thus prop up the fund ylds.... its not like those 30yr high yld bonds just went away... they still pay high coupons..

 

[kevink]

That’s past performance - no future guarantees. If you ALREADY owned bond funds, you did very well this year due to the sudden drop in rates. But that will not be repeated, unless rates go negative.....

Also, Total Bond Fund holds a lot of corporate debt, whereas Clements was focusing on treasuries.

Exactly. Clements, in an earlier post, said he was going with a barbell of half short-term TIPS, half short-term Treasuries (e.g. VTIP, VGSH) since he's agnostic about whether we'll have inflation or deflation.

Unfortunately short-term TIPS only offer a modicum of protection against "sudden" inflation and both they and long-term TIPS have negative coupons right now. iBonds are an infinitely better option but the 10K per person per year purchase limit and having to open a separate Treasury Direct account will dissuade many.

To Audreyh1's point bonds have had a decent run this year thanks to the March market panic but there's just not much room left. This article makes a pretty compelling argument, in my opinion, for why even short-term Treasury funds aren't worth owning at this point, let alone Total Bond or IT Treasuries:

https://seekingalpha.com/article/4376259-short-term-treasury-etfs-no-longer-make-investment-sense

 

[njhowie]

I'm betting on another market crash followed by Fed panicking and going negative on the rates. Given that they have no other place to go but below zero and the fact that market and politicians are addicted to Fed's intervention, it's not unlikely. All we need is a failed vaccine and we're in the dumpster. And that's the only reason I hold on to some LT US treasuries. Otherwise I'd buy more Chinese government bonds.

That is a likely/possible scenario. There are others, as horrific or even worse.

At the end of the day, the Fed cannot control where rates go - the market wields more strength than the Fed, unless the Fed prints to infinity and devalues the USD to nothing, making inflation take off. At what point do we believe the Fed will back off when it becomes clear that failure is the only outcome? Remember George Soros shorting the British Pound when it was teetering on the brink? How far does the Fed go before a similar scenario arises?

https://theeconreview.com/2018/10/16/how-soros-broke-the-british-pound/

What kept the pound from nose diving in value was simply the British government’s guarantee that it would keep the value propped up, and the market had faith that it would. As long as everyone believed that England would stay indefinitely committed to buying pounds and keep it in the agreed upon level, the status quo was maintained.

Following an interview with the then President of the Bundesbank, Helmut Schlesinger, it was revealed that the pound sterling was one of those currencies that could “come under pressure” and be devalued since it was trading at levels that were far away from its inherent value. This caused a huge dent in market sentiments and probed major speculation about the pound and the possibility of it being devalued.

Meanwhile in New York City, Soros and his Quantum Fund had been building a $1.5 billion short position anticipating that an overvalued pound would be compelled by the market to drop down to its equilibrium price devoid of any artificial intervention. A short position, in essence, allows an investor to garner profits when the price of a commodity or security goes down rather than up.

Since the pound was trading at the lower end of the agreed level, this was a brilliant and well thought out strategy. If the pound tanked, Soros would make billions owing to his short position. Any increase in the value of the currency is virtually impossible given the fact that the market was now convinced that the pound was overpriced. It was already trading at low levels and required support from the Bank of England to remain on its current level.

And so, on the morning of Wednesday September 16, 1992, Soros and his fund increased their short position against the British pound from $1.5 to $10 billion. Consequently, Soros borrowed and sold pounds from anyone that he could. Other hedge funds found out about the bold trade and decided that it would be prudent to short the pound too.

Therefore, by the time London markets opened, tens of billions of pounds had been sold, placing the pound to be trading dangerously close to below the levels mandated by the ERM. British officials responded by buying up the pound, depleting its reserves of foreign currency in order to prop up the price and induce an uptick in the demand for the British sterling. However, the huge supply glut could not be mitigated by the purchase of the currency and its value still remained surprisingly low.

Having no other option, the British government was forced to drive up interest rates to manage the currency and prevent it from free falling. At around noon local time, an increase in interest rates of 200 basis points, from 10% to 12%, was announced. However, the pound continued to plummet. Investors around the world were convinced that the currency would continue its downward trajectory thereby prompting them to offload the currency and cut their losses. This caused the situation to exacerbate further.

 

[Lsbcal]

Well it looks like there is quite a spread in strategies here.

After looking at some strategies of the past I decided to do the following with our 60/40 portfolio:

Take the 22% that we have in short and intermediate investment grade and split that into 30% SP500 plus 70% intermediate Treasuries. The rest of our bonds are in high yielding iBonds and TIPS paying positive rates. So this raises the equity part of the portfolio to 67/33.

That 30% SP500 is market timed using a simple moving average approach to minimize downside risk. I've posted a thread on this strategy some months ago. I know most here will puke at the thought of market timing but I've been doing this successfully for many years. And market timing just to beat bonds has a long history of success but few people use it for this reason.

 

[NW-Bound]

Well it looks like there is quite a spread in strategies here.

It does not matter what you choose, risks come with rewards. Understanding the risks is crucial no matter what one does. A guy has got to stick with what he is comfortable with.

 

[Starsky]

I like the author's Role 3 rationale for owning bonds right now. The returns, though meager, are not terribly threatened by inflation. My only concern regarding inflation is that if we de-couple from China that it could drive the cost of many common products higher until a new source of cheap labor is found and exploited. It would be a different source of inflationary pressure than we have typically seen in the past.

The general consensus seems to be that we are going into a deflationary mode and overall inflation will not occur until the Fed does something dramatic - like direct stimulus payments to taxpayers, or gets rid of cash, or both. Inflation is highly unlikely because the terrible economy is cratering the demand necessary for it to occur. (With the exception of certain assets that have temporarily artificial high demand for their products because of tight supply and/or fear-based hoarding - like Real Estate and guns and ammo.)

In this deflationary scenario, Bonds are seen as the one of the safer options; and bond returns beyond the coupon rate are highly feasible - until the Fed develops new tools to stimulate consumption and/or inflation.

There are so many convenient ways to own bonds that mitigate the long-term risk - and so much uncertainty in owning stocks right now - it seems irresponsible not to have a piece of the portfolio in that asset class simply to diversify risk.

 

[VanWinkle]

I like the author's Role 3 rationale for owning bonds right now. The returns, though meager, are not terribly threatened by inflation. My only concern regarding inflation is that if we de-couple from China that it could drive the cost of many common products higher until a new source of cheap labor is found and exploited. It would be a different source of inflationary pressure than we have typically seen in the past.

The general consensus seems to be that we are going into a deflationary mode and overall inflation will not occur until the Fed does something dramatic - like direct stimulus payments to taxpayers, or gets rid of cash, or both. Inflation is highly unlikely because the terrible economy is cratering the demand necessary for it to occur. (With the exception of certain assets that have temporarily artificial high demand for their products because of tight supply and/or fear-based hoarding - like Real Estate and guns and ammo.)


In this deflationary scenario, Bonds are seen as the one of the safer options; and bond returns beyond the coupon rate are highly feasible - until the Fed develops new tools to stimulate consumption and/or inflation.

There are so many convenient ways to own bonds that mitigate the long-term risk - and so much uncertainty in owning stocks right now - it seems irresponsible not to have a piece of the portfolio in that asset class simply to diversify risk.

+1 Well said!!

 

[kevink]

Of course no one knows whether we'll see inflation or deflation, but a prolonged bout of the latter is something the U.S. has never experienced and is unlikely to in the future, for reasons William Bernstein goes into in considerable detail in his excellent booklet "Deep Risk:How History Informs Portfolio Design."

From the review in Forbes (link below):

"Deflation, on the other hand, is the least likely to happen. It is good for bonds and bad for stocks. Solutions include cash, bonds, and international diversification, as well as gold. But using bonds and bills carries a high cost if we experience inflation rather than deflation."

Of course Bernstein's book, while recent, was published before today's era of unprecedented negative real returns on Treasury bonds of all durations. Starsky's comment about mitigating [deflation] risk now applies only to long-term Treasuries but the downside risk of holding them if interest rates spike far exceeds any remaining benefit they might provide in the unlikely event of prolonged deflation. IMHO a mixture of the other assets Bernstein recommends - all of which also help mitigate inflation - along with ample safe cash makes much more sense.

https://www.forbes.com/sites/wadepfau/2020/03/04/inflation-deflation-confiscation-devastation-the-four-risk-horsemen/#29d2dff43dac

 

[dixter]

There is nothing we can do about deflation or inflation... I am surprised why anyone would buy a Treasury Bond with rates this low... you can instead get a decent rate of return by just buying a well rated Corporate Bond... if you compare a " Safe " Treasury Bond to a " Safe " Corporate Bond like say, Apple that is AA1 rated and pays a coupon of 4.65%... if you buy a Treasury Bond do you really need to worry yourself about inflation/deflation.... why? Apple is in better financial shape than the USA Treasury... think about that... and of course there are many many options to Corporate Bonds than just Apple...

 

[Markola]

Well it looks like there is quite a spread in strategies here.



.

And mistakes will be made, since no one can predict the future. So my strategy is to sit tight on our globally-diversified, 50/50 portfolio of index funds and try to maintain a 20 year-plus view. By then, hopefully, what ever needs to cycle through, will cycle.

 

[Lsbcal]

There is nothing we can do about deflation or inflation... I am surprised why anyone would buy a Treasury Bond with rates this low... you can instead get a decent rate of return by just buying a well rated Corporate Bond... if you compare a " Safe " Treasury Bond to a " Safe " Corporate Bond like say, Apple that is AA1 rated and pays a coupon of 4.65%... if you buy a Treasury Bond do you really need to worry yourself about inflation/deflation.... why? Apple is in better financial shape than the USA Treasury... think about that... and of course there are many many options to Corporate Bonds than just Apple...

Corporate bonds and other options include an equity like risk. So the logic in using Treasury bonds is to have a very low risk bond stash with a suitable percentage of equity. This is an attempt to isolate the risk into a pure equity component and a pure bond component. I cannot prove that the risk isolation is superior but it seems to have beaten some alternatives I've studied with data going back to 1987.

What is the duration on the Apple bonds? Why are they paying such a premium over an equivalent duration Treasury? Not saying you are wrong to buy these bonds, just curious how the market prices these.

I found this article on Apple bonds: https://www.barrons.com/articles/apple-is-the-latest-to-tap-bond-markets-in-a-record-setting-week-51597344992
It says for a 10 year Apple bond the rate is 1.25% to maturity. That would be the max maturity I'd personally consider.