Here’s a challenge: See if you can find any thoughtful, successful, experienced and honest investors who think that bonds are an attractive place for money. Is there a doubt in anyone’s mind that bonds are bad investments today? How many luminaries do I need to quote? Warren Buffett? “Now is a terrible time to buy bonds.” Jeremy Grantham? “We are literally running out of superlatives to describe how much we hate bonds.” Or perhaps Jim Grant? “The Fed has somehow managed to take the income out of fixed income and the yield out of high yield.”
Over the last 30 years, interest rates on 10-year Treasury bonds declined from a high of nearly 16% to a low of 1.5%. Bond funds generated abnormally high returns—so high that they often competed with traditional growth investments. This was the golden age of fixed income: Bonds generated competitive returns as they hedged portfolios against stock market volatility. I think that we can all agree that those days are over—and bond investors are now scratching their heads while searching for an intelligent direction.
Bill Gross is a rarity in the investment world: a bond manager who ponders publicly whether he and his competitors just had an amazing run of good luck: “All of us…, yeah—me too, have cut our teeth during perhaps a most advantageous period of time, the most attractive epoch that an investor could experience.” This kind of humility from someone who really does know what he’s doing is why his observations have value.
His observation, moreover, is that the wind was at investors’ backs for the last 50 years—a result of a steady expansion of credit. But he warns us that the return to GDP from each dollar of credit has been diminishing at an increasing rate so that we are quickly approaching the juncture where “investible assets pose too much risk for too little return.” While Gross isn’t suggesting that investors not own bonds, to his credit he is on the record that they diversify elsewhere.
Investors are listening. Since the end of May, according to the Investment Company Institute, they have liquidated over $100 billion of their bond fund holdings, $40 billion more than they sold at the height of the financial crisis in 2008—and the fourth largest drawdown of bond fund assets in history. The expectations of professional investors also are negative. According to a recent survey by Bank of America-Merrill Lynch, 57% of global fund managers are underweight bonds, and fully 97% expect long-term rates to be higher over the next 12 months. That is as close to unanimity as you will ever see in a legitimate survey, and reflective of the growing consensus that bonds are now hazardous to our financial health.
You don’t have to be an expert to conclude there’s a lot more upside than downside for interest rates, and for bondholders; that there’s a lot more risk than yield. Even after one of the sharpest rises in interest rates in years, yields remain pitifully low. The boomers are starting to retire and they are desperate for income. If bonds can’t generate what they need, they are willing to look elsewhere—and Wall Street is ready and able to provide solutions for disaffected investors.
I began “Investment Sense” as a quarterly newsletter 20 years ago to reframe investment issues where public perception was either overly simplistic, short-sighted or just incorrect. My goal was (and is) to help investors look more critically at their assumptions so that they can make healthier decisions and become better investors. To that end I offer two suggestions:
First, without disputing the conclusions of Messrs. Buffett, Graham and Grant, I believe it is a considerable mistake for investors to throw bonds under the bus simply because of interest rate risk. It is compellingly easy to envision a narrative where it is next to impossible to make decent returns from bonds in a rising interest rate environment. But as real as interest rate risk is, there may be even more risk in an investment strategy built on a single narrative, however plausible.
The idea that the next 30 years will be the inverted version of the last 30—while statistically possible—is highly improbable. So abandoning bonds altogether in favor of untested alternatives doesn’t sound like a reasoned strategy. Alternatives are certainly worth considering, but so is finding those few managers who, even during the bull market, discovered pockets of unique opportunity they could exploit. They toiled outside the mainstream because when everything was working there wasn’t a lot of interest in unique strategies. But now there is—and unconstrained go-anywhere strategies are popping up like mushrooms after a rain.
However, the universe of managers who are experienced enough to successfully identify and exploit unique opportunities in the bond market is far smaller than the demand. Patient investors, who understand this law of investment physics, will wait until they find the right combination of good people and good process—because they know that the penalty for making poor choices can be far more devastating than a disappointing period of low returns.
My second suggestion is much more radical, but I believe there is a lot of clarity to be gained by considering the following observation: Bonds are not investments. I’m not suggesting that investors shouldn’t use them; I’m just stating a fact. Bonds are not investments. The purpose of an investment is to put aside some money today so that at some point in the future, what we put aside is worth more (in purchasing power) than when we started. That is what we mean by an investment and its internal engine: growth.
A bond is an agreement by which during its life the issuer will pay the holder a set amount each year, and then at maturity, the face value of the bond. Sometimes the annual payments are enough to cover inflation (before taxes), sometimes they aren’t. But the point of the arrangement is that it’s guaranteed—so our expectations are necessarily different than with an investment, which by its nature is not guaranteed.
The central attraction of bonds is that their annual income and value at maturity are reliable—and in a world where so little is reliable, that feature has considerable value, and not just in our financial lives. There are legitimate rational and emotional reasons for guaranteeing a portion of one’s nest egg. Sometimes the income is attractive, sometimes it isn’t. But there are few alternatives that so simply and effectively fill the need for having guarantees as bonds.
The easy returns bond holders enjoyed for so long are over, and at best the future looks challenging. Investors who oversimplify the risks of bonds while ignoring the benefits do so at the peril of building their investments on a foundation of sub-standard thinking. Whether you decide to own bonds or not, the why of your choice is what will make the difference when circumstances force you to question it. The best way we can honor the conclusions of Buffett, Graham and Grant is to think about them critically—because that is what they would do.