What Should You Know About Investing In Bonds? Run Like Hell.

October 19, 2017

What Should You Know About Investing In Bonds? Run Like Hell.

  • The recommended portfolio split is still 60% stocks and 40% bonds, which is a terrible split if you ask me.
  • I’ll show you the current risk reward bonds have and what you can expect from them in the future (treasuries and junk bonds).
  • There are two situations with owning bonds that aren’t such a bad idea.

The Current Bond Environment

Bonds, as stocks, have been in a bull market for the last 35 years because interest rates have been on a constant decline.

Since 1981, a 10-year Treasury bond portfolio has returned 14.6 times its initial capital.

Figure 1: A $100 10-year Treasury bond portfolio since 1981. Source: Damodaran.

However, bonds have also had some bad years. In 2013, the 10 year Treasury bonds lost 9.1%. In 2009, 11.12%. In 1999, 8.25%, and 8.04% in 1994. The decline in the 10-year bond portfolio with coupons is due to increases in the required interest rate.

In 1994, the 10-year Treasury yield increased from 5.77% to 7.8%. In 1999, it increased from 4.6% to 6.66%. In 2009, it increased from 2.18% to 3.83%, and in 2013, it increased from 1.87% to 2.99%. So increases in expected 10-year treasury yields of about 100 to 200 basis points (1% to 2%) usually lead to losses of around 10% over a year.

Figure 2: Increases in required yields lead to bond portfolio losses. Source: FRED.

The effect interest rates have had on 10-year bonds is best explained by the SEC and their paper on how higher interest rates lead to lower bond values and vice versa.

Figure 3: Interest rates and bond values if interest rates increase. Source: SEC.

Of course if interest rates rise the higher yield should cover for the capital loss, but if interest rates increase quickly, then the higher rate usually isn’t enough.

Now imagine what a complete reversal of the 35-year bull bond market trend would do to bond values and bond portfolios. Let’s say central banks around the world lose control of their monetary easing policies spurring inflation which increases the required interest rate from the current 2.3% to 10% in one year. A 10-year treasury bond bought in 2017 would lose 35% of its value as the required yield is much higher and the discounted value received at maturity is much lower when a higher discount rate is used.

If the 30-year bond interest rate goes from the current 2.86% to 10% in the next 12 months, the loss on a bond bought in 2017 would be around 65%.

So the risks of owning bonds, and I’m talking about Treasuries here where the risk of issuer default is practically zero, is anywhere from 35% to 65% for longer term bonds. All that risk for yields of 2.3% on the 10-year Treasury and 2.86% on the 30-year Treasury isn’t my idea of a positive risk reward investment. On the contrary, bonds, like stocks, currently represent a negative asymmetric risk reward investment.

The saddest thing is that pension funds usually own stocks and bonds as a proper diversification play and when I see the risks of what can happen if interest rates go up to both portfolios, I get really worried about the current and future retirees depending on their pensions for a comfortable retirement.

I firmly believe that those who want safe yields should look for real estate and not bonds. Both assets seem inflated now, but at least you have inflationary protection with real estate which is something you don’t get with bonds, especially long-term bonds.

High Yield Or Junk Bonds

Many investors are attracted to high yield or junk bonds thanks to the higher yields. However, the higher yield is definitely not worth the risk at this point in time.

The current high yield is at extreme lows and just imagine what will happen to those yields if we see similar turmoil as we saw in 2009 where yields suddenly went from 7% in 2007 to 22% in 2008.

Figure 4: U.S. high yield can go only up from here. Source: FRED.

Now, you could say that the higher yield will cover for the principal loss, but there is another risk in owning high yields that nobody talks about. In the last 10 years, there have been a proliferation of ETFs and high yield ETFs, though it’s better to call them junk ETFs. Such a situation is extremely risky.

The iShares iBoxx $ High Yield Corporate Bond ETF has issued 229,400,000 shares where the value of one share is $88.14. Thus the market cap of the ETF is $20.2 billion. The problem is that most of the bonds owned are thinly traded and if there is a run on junk yielding ETFs where people sell their high yields in a panic, there will be no market for the huge supply of bonds.

As an example, the ETF mentioned above owns $125 million of the US67054KAA79 SFR GROUP SA 2026 7.38% coupon bond. The total issue is $5 billion. This means that just this one high yield ETF owns 2.5% of the issue. The thing to understand with junk bonds is that when there is turmoil, nobody wants them anymore and if an ETF is forced to unload, there is a high probability that there will be no market, especially if more ETFs of the same kind are forced to do the same.

Thus many of those bonds will be selling at cents on the dollar. This is a risk not worth running for a yield of 5.5%.

Stay Away From Bonds

In general, if you don’t like losing money, you should stay away from bonds for the long term with two exceptions.

Parking your money in short term treasuries with the expectation of higher yields or lower stock prices might be a good idea.

The second exception is directly buying high yield bonds where you have done proper research and disagree with the rating which makes the payment secure no matter what happens. After all, the rating agencies don’t have such a great track record. Remember the triple AAA mortgage bonds of 2007.

Longer term bonds look like a bad idea because interest rates globally can’t go much lower and you have seen what happens to bond values if interest rates increase.

There’s some food for thought.

By Sven Carlin Bonds Investiv Daily Share: