Google “Bond Bubble” For a Laugh
The term “bubble” is bothersome when describing bonds. Investors are not clamoring to buy 10-year U.S. Treasury bonds with the expectation of getting rich. The .com euphoria of the early 2000s is a textbook definition of a bubble; retail money chasing riches. Cab drivers were pitching their favorite tech stocks to their customers. When my Uber driver starts talking up his favorite maturity on the yield curve I’ll start to worry about excessive bond valuations.
It’s true interest rates and bond yields have been compressed to structural lows by aggressive global monetary policy. Bill Gross has coined the term “new normal’ to describe the paradigm shift of low interest rates and sluggish global growth. For investors, bond return expectations should be revised downward due to the lower interest rate environment (new issue investment grade bonds have paltry yields), however this doesn’t mean bonds should be punted for dividend paying stocks or other income proxies.
“Bond Bubble?” We think not.
When everyone agrees, something else happens– How long have we been hearing about interest rates & bond yields moving higher? It’s been an annual forecast for market experts and the financial media; it’s also been the most incorrect forecast during the past decade.
Global yields– The German Bund 2-year yield is -.92% (yes, that’s a negative yield). For a German investor, the U.S. yield curve looks attractive. They are getting a “safe-haven” asset, additional yield, and an appreciating currency. Global capital flows to friendly environments. Depressed global yields should continue to put an artificial lid on U.S. bond yields.
Demographics– Baby boomers’ thirst for retirement income is real. Appetite for risk is limited while demand for income to supplement retirement creates a powerful demand for fixed income.
Sluggish Growth– U.S. GDP growth has been below 3% for 11 straight years. Inflation has been muted. Tough to see structurally higher interest rates in such a challenged environment.
Cautious Fed– Continues to err on the side of caution, aware of the financial market sensitivity to unexpected changes in policy.
Building Efficient Bond Portfolios
Be mindful of how sensitive your bond portfolio is to interest rate changes (duration)– Most financial advisors have advocated for shorter maturity bonds with the expectation that interest rates will be moving higher. They have missed out on valuable income and opportunities in longer maturity bonds.
Prefer to own individual bonds– Buying individual bonds takes additional time and skill, but is the most efficient way to own fixed income. We know exactly what we own, expected coupon payments, zero ongoing cost, and what we will receive at maturity. Low cost ETFs make sense for niche asset classes i.e. high yield, preferreds, international bonds.
Get creative– Buying the entire Barclays U.S. Aggregate Index (the entire bond market) is a decent strategy, but is sub-optimal. For example, we own slightly lower quality bonds for 1-3 year maturities to generate additional yield to complement our high quality, longer dated bond positions.
In our opinion, bonds are still the best way to hedge total portfolio risk. They offer an uncorrelated asset class that moves differently than equities. In a slower growth environment, dependable income can smooth returns and provide downside protection. In other words, don’t let those that have been habitually wrong tell you what happens next.