The Death of the Cult of Bonds
By now everyone has heard of Bill Gross’ comments about the likely decline of equities, and everyone has heard the explanation for why his math is wrong. I don’t believe that Gross’ letter was anything more or less than a marketing piece designed to attract people who want to dump stocks and buy bonds. Surprisingly he does mention in passing towards the end that we have to lower our expectations for bonds.
Since the early 80s, interest rates have gone from record highs to record lows. Based on the simple math of markets, this has created a bull market for long-term bonds that lasted even longer than the run for stocks (which started a few years after the last time the media announced the death of equities).
Which brings us to today. If falling interest rates create rising prices for long-term bonds, and interest rates are at record lows, who wants to buy bonds? Apparently quite a few people do since this is what keeps the interest rates down. When the supply of willing buyers dries up, issuers will be forced to raise interest rates to keep borrowing as parts of Europe are demonstrating for us.
However this is a case where I disagree with the market, or at least have a different situation. I’m confident enough in our other assets and our future income that I don’t feel the need to get marginal safety at any price, even the negative nominal yields you can get in Europe. Which leads me to ask why I would want to hold a lot of bonds.
Since we still manage a simplified portfolio using only 4 index funds, our bond allocation comes from the DEX universe index which has an average term of around 9 years and duration of around 6 years. This carries a fair bit of exposure to rising interest rates, and pays very little at the moment. Last time I did a comparison it was less than the dividend yield on some of the stock indexes we use. If both the immediate and the future expected returns are higher on stocks, I will take those.
I have stopped all bond purchases, and the allocation has drifted down to 5% of our portfolio (with another 1/3 of that amount in a Mortgage Investment Corporation that actually has an interesting yield and a term under 2 years). I would dump this altogether but since stocks aren’t at irrational lows now they could fall a bit more and the bonds could provide some useful buying power. This would take something big of course.
At this point stock investors seem to be pricing in bad news that is only theoretical, so even announcements of new trouble could lead to a rising stock market if they aren’t as bad as expected. Since we are still rapidly adding to our stock portfolio I get excited every time prices fall. At this pace it will take 26 months or less to double our portfolio through contributions, so that is still similar to having a large bond/cash allocation that we will move into stocks.
There is one area where you can be a double-contrarian though. If everyone is avoiding duration because they recognize the risk of rising interest rates, maybe it is priced right or even cheap. And if you do want fixed income, maybe you can get some better interest rates without a lot of risk by going for medium or long terms.