So much for the safety of bonds

Bonds had a lousy 2013.  Most investors think bonds are always safer than stocks, but it depends on what you are buying and the price you pay.  

Last year, the 1-3 year Treasury Bond ETF (SHY) generated a 0.23% return.  That’s one-tenth of inflation.  

The 3-7 year Treasury Bond ETF (IEI) returned -1.95%.

The 7-10 year Treasury Bond ETF (IEF) returned -6.12%

The Treasury Inflation Protection Bond ETF (TIP) generated -8.65% return.

The 10-20 year Treasury Bond ETF (TLH) returned -8.48%.

The 20+ year Treasury Bond ETF (TLT) returned -13.91%.

Oh, by the way, the S&P 500 ETF (IVV) returned +32.31%.

What happened?  As has been long predicted, interest rates went up.  That’s it.  When interest rates go up, bond prices go down.

When you buy bonds at high prices and low yield, you get return-less risk instead of risk-less return.

Bond yields are higher, but not high relative to history.  The bond bull market that began in the early 1980’s saw yields in the teens.  Today long government bonds are yielding 2.6% to 3.6%.  I don’t know which way they will go, but yields still have more room to go up than down.

Bonds are safe when they are priced to provide good returns, not at any price–just like stocks provide good returns when priced accordingly.

No financial instrument is inherently safe.  It depends on what you buy, and the price you pay.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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So much for the safety of bonds

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

 

Whether they want to or not, investors face a basic choice: some options will allow you to achieve your goals, and others won’t. To reach your financial destination, you can either:

  • get lower returns and save more money over time (thus having less to spend )
  • get higher returns and save less money over time (thus having more to spend)

There’s no option to save less and get low returns–that won’t work.

The difficulty investors face is that they want to take little or no “risk”–avoiding anything unpopular or seemingly scary. But, what if the avoidance of supposed risk prevents you from reaching your goals?

A beautiful drive in the country can be pleasant, but if it doesn’t your destination, then it’s the wrong route. You can make valid choices among routes that will get you where you want to go, but you can’t successfully ignore whether the route will get you there.

With investing, you need to clearly understand your options, you must flesh-out the pro’s and con’s of each, and then you must choose your path.

Right now, investors face a fundamental choice between risk and reward. On the one hand, you can choose options that will likely do well in the short run and terribly in the long run. On the other hand, you can choose options that will will likely look unrewarding in the short run, but ultimately be much more rewarding in the long run. The choice is between: 

  • cash (including checking, savings, CDs, etc.)
  • bonds
  • commodities
  • stocks
  • real estate

Cash and bonds will likely do well in the short run and be an unmitigated disaster over the long run. Cash and bonds have done well over the last 30 years as inflation and interest rates have gone from mid-double-digits in the early 1980’s to low-single-digits now. This process simply cannot repeat (going from 2% inflation to -11% inflation?). This means cash and bonds may look good in the short term, but will almost certainly provide terrible returns over the long run. To choose cash and bonds, you must either be able to perfectly time the point when inflation and interest rates change direction, or you will not reach your financial goals.

Commodities are likely to do well in the short to intermediate term, but then drop like a rock at some indeterminate point in the future. Commodities have done very well over the last 12 years and are likely to continue to do so over the next 5 to 10 years. In the not-too-distant future, though, they will fall off a cliff and provide investors with very poor long term returns. Any observation of long term (inflation adjusted) commodity prices will make this abundantly clear. Like with bonds, commodities will go from great to terrible very quickly, and unless you can time that switch perfectly, you will not reach your financial goals.

Another option is stocks. Stocks have done poorly over the last 12 years, and are likely to provide unexciting returns over the next 5 to 10 years. The outlook beyond that, though, is bright indeed, with 10%+ average returns. The problem is that very few investors are willing to look beyond the short term–or their wished-for ability to time the market–to reap the much better long term results from stocks.  

The last option is real estate. Real estate has had a dreadful 6 years, and is obviously an unpopular place to invest right now. The returns from real estate are likely to be much better than cash, bonds and commodities over the long term, but the short term looks unenticing. Real estate is another choice with little short term upside, but good long term reward.  

To me, the choices seem clear. Cash, bonds and commodities provide short term “reward” with significant long term risk, and stocks and real estate provide short term “risk” with real long term reward. If you want to reach your goals, and don’t suffer from the delusion you can time the market, then stocks and real estate are clearly the best options.

If your financial plan permits lower returns, real estate is likely to be a less bumpy ride. If you require or desire higher returns–and the vast majority of people do–then stocks are the best option.  Choose wisely.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

You choose: short term "reward" and long term risk, or short term "risk" and long term reward

Bonds and Gold

David Malpass hit the nail on the head with his editorial Beyond the Gold and Bond Bubbles in the Wall Street Journal today: bonds and gold have done well because people fear both deflation and inflation.

I’ve been surprised to see both gold and bonds do so well over the last decade.  After all, deflation and inflation are opposites: when one performs well the other usually doesn’t.  This makes bonds and gold both doing well a bit of a paradox. 

But in today’s mixed message environment, it makes sense from a certain perspective.  Investors are running scared.  They seek safety in some form–any form. 

They correctly see that bad debt (lending which can’t be repaid) leads to deflation, so they want to own bonds as protection.  Just look at Japan over the last 20 years: bonds performed much better than stocks.  Or, look at America during the Great Depression: bonds did much better than stocks.

But, investors also fear inflation, which is caused by too much currency growth relative to goods and services.  Witness Weimar Germany in the 1920’s or the United States during the 1970’s.  In both cases gold protected wealth better than stocks or bonds.

The problem with this reasoning is that it works…until it doesn’t.  Let’s look at what Paul Harvey called “the rest of the story.” 

Bonds were a lousy investment from the bottom of the Great Depression until the 1970’s.  Bonds will likely be a very poor investment in Japan over the coming 20 years.

Gold was a great investment in Weimar Germany…until hyperinflation ended.  Then it tanked.  Same with 1970’s inflation here in the U.S.: gold was great…until it declined 6% a year for 20 years.

Investing to catch the waves of inflation and deflation require excellent market timing.  It only pays to ride the wave as long as you know exactly when to get off.  Getting the timing wrong–even by a little–will lead to poor results.  But, in case you don’t know, no one is good at consistently timing the market (despite all the time, effort and brainpower devoted to it). 

Warren Buffet doesn’t time the market.  Neither did Peter Lynch.  Look at the Forbes 400 some time and scout out the market timers–you won’t find a single one.  Trying to time the market doesn’t lead to permanent wealth–it leads either to temporary or decreasing wealth.

Which is why most investors shouldn’t focus on bonds and gold.  If you can time the market perfectly–and good luck on that–you can ride bond/deflation or gold/inflation.  If you are a mere mortal, then don’t try juggling nitroglycerin. 

If you want to build permanent wealth, you should do what Warren Buffett and a herd of other smart investors do–buy productive assets at cheap prices, which is when everyone hates them.  Productive assets are things that generate cash.  Gold doesn’t.  Bonds do, but the cash they generate isn’t protected against inflation (except for TIPS, but they have their own problems).  You have to own productive assets to really be protected against both inflation and deflation.

Examples include real estate, stocks, businesses, rental equipment, employment, education, etc.  These are assets you put money into and get back over time.  They can adjust to both inflation and deflation. 

Does that mean they do well in all markets?  NO!  Investing is not about what does well over a week, month, quarter, year, or even 5 years.  You invest for the long term, not for a short term kick-back–that’s speculation!

But, producing assets work like a charm during both inflation and deflation.  Look at the record of stocks, real estate, owning a business, rental equipment, education, or any employment during periods of inflation and deflation.  They do poorly initially, but work very well over time.  That’s because they can adjust to inflation and deflation, whereas bonds and gold cannot (gold will maintain, but not grow, value over the full cycle).

Investors flooding into bonds and gold are likely to look brilliant for a while…until they get slaughtered.  The cycle on bonds and gold tend to turn very quickly.  It will only be obvious in hindsight that the tide has turned–and by then it will be too late.

Investors patient enough to invest in producing assets at cheap prices will do well–over the long run–regardless of whether we experience inflation or deflation.  That’s how I’m betting.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds and Gold

Mixed up markets

When most people think of “the market,” they think of the stock market.  But, there are other markets that are equally or more important to pay attention to.

For example, bond and currency markets are bigger than stock markets.  Commodity markets are important, too, but most people ignore them.

Why are other markets important, you may ask?  Because they frequently bring warnings of contradictory premises held by different participants in each specific market.

In a normal state of affairs, currencies and gold should move in opposite directions.  That’s what’s happening right now, especially with gold flying high and the U.S. dollar crashing.  All good there.

Normally, commodities move opposite the dollar.  Commodities have been soaring and the U.S. dollar is tanking, so everything looks as it should there, too.

Next, we come to bonds.  Bonds and commodities normally move opposite each other, and here we run into our first contradiction.  Commodities are soaring and bonds are climbing, too.  The first indicates inflation and fast economic growth and the second indicates deflation and slow or declining economic growth.  Both markets can’t be right.

Furthermore, commodities and stocks usually move opposite each other, which is just another way of saying bonds and stocks tend to move together.  Climbing commodities indicates inflation and high interest rates (lower bond prices) which both tend to be bad for stocks.

Don’t get me wrong, I’m not saying these relationships exist at all times and all places.  But, when I see markets seeming to indicate different opinions, I take notice.  It means markets are mixed up and one will turn out to be right and the other wrong.

Things are pretty mixed up right now.  The dollar is sinking, commodities are climbing, as are stocks and bonds. 

The dollar is sinking because the Fed is going to print money to try to further revive our flagging U.S. economy.  That means a lower U.S. dollar, higher inflation, and rising commodities and gold.  So far, so good.

But, a lower dollar, higher inflation and rising commodities is inconsistent with high bond and stock prices.  High inflation is bad for bonds and stocks.  That contradiction must be resolved.

To further muddy the waters, rising bond prices usually correspond with higher stock prices, but not super high bond prices.  Super high bond prices means very low bond yields, which tends to indicate low growth, deflation and economic stagnation.  And, that’s usually NOT a recipe for higher stock prices.  As illustration, Japan’s bond prices have gone up for 20 years while its stock market has lost 75% of its value. 

Bonds are indicating slow or negative growth and stocks are rallying, and that doesn’t make sense.  Bond markets are right more often that stock markets, so the on-going stock rally might be in danger. 

High gold and commodity prices and a falling U.S. dollar should mean lower bond prices and high bond yields (a.k.a. inflation).  Once again, this contradiction must be resolved.

Over time, all markets will sync back up again.  Either bonds and stocks will tank and the dollar will continue to fall; or, commodities and gold will tank, the dollar will rally, and stocks and bonds will continue to rise.  It may take time, but markets will re-achieve consistentency.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Mixed up markets

Bonds and cash just aren’t that safe

Bonds are seen as safe. So is cash. But, that’s not necessarily true.

For starters, bonds and cash are susceptible to higher tax rates than stocks. Whether anyone likes it or not, interest on bonds and cash are taxed at much higher rates than dividends and capital gains on stocks. That differential may change with new tax laws, but even then, stocks are likely to be taxed at lower rates.

Most significantly, bonds and cash are more prone to suffer from the impacts of inflation. That may not seem as dangerous as a 50% stock market plunge, but 4.14% inflation over 10 years will do the same thing (and is much more likely to be a permanent 50% loss versus a temporary one for stocks). Does anyone really want to bet that inflation won’t be above 4% over the next 10 years considering huge government debt and budget deficits?

Finally, bonds and cash can be defaulted on. This is probably the risk most people dismiss as too unlikely, but a low likelihood is not the same as no likelihood. Bonds are more likely to default than cash, and stocks are more likely to go to zero than bonds, but bonds are not without default risk. If you hold government bonds and think they can’t default, a re-reading of the history of Germany, Argentina, Russia and the Confederate States of America is in order. Think cash is default free? Check again. History has many examples including Weimar Germany, France after the South Seas Bubble, or any other example of cash not backed by specie (not yet and never aren’t the same thing).

Bonds and cash can be safer than stocks, but not always. Bonds are a promise to pay, but that promise can be broken. Cash is a note (debt) issued by the Federal Reserve as legal tender, and that promise too can be broken. Bonds and cash are much more impacted by inflation and have higher tax rates than stocks. They are not without risk.

I was reminded of this recently when I read that individual investors were generally selling stocks to buy bonds over the last year. They are rushing for a safe haven to avoid the pain of another downdraft. In the meantime, they have missed the market rally and are hoping to time the market. The history of individual investors, especially as a herd, being right on something like this is extremely poor.

The very fact that so many retail investors are racing to bonds together as a herd is enough to remind me of how badly bonds and cash can do. The next couple of years are likely to remind investors that not even bonds or cash are completely safe.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The peril of bonds

Long term bonds have beaten stocks for decades.

As reported by Rob Arnott (chairman of Research Affiliates), 20 year bonds have provided better returns than the S&P 500 starting any time from the 1979 through 2008.

That’s a startling fact to many investors who’ve been told, ad nauseam, that stocks always do better than bonds over the long run.

This out-performance by bonds has not gone unnoticed by investors, who are selling stock mutual funds and buying bond funds.

Is it time to abandon stocks and buy bonds?

No.

You shouldn’t drive your car by looking in the rear view mirror, and you shouldn’t invest your money that way, either. The past can be a wonderful guide to the future, if and only if situations are sufficiently similar.

But, the situation over the next 30 years is highly unlikely to be the same as it was over the last 30 years.

For starters, inflation was in double digits 30 years ago. When inflation is high, bonds sell at super-cheap prices. When high inflation is tackled, as it was by Paul Volcker in the 1980’s, and continues to decline for another 20 years, as it did, then bonds have remarkable performance.

That is not the situation today. In fact, reported inflation is at an all time low, showing its first annual decline since the mid 1950’s. Bond yields reflect this low inflation with record low yields.

Bonds will not perform as they did over the last 30 years because inflation isn’t starting high and going to record lows. Count on it.

In addition, the threat of growing inflation is as high now as it was the last time bond rates were this low, in the 1960’s.

At that point in time, government spending was going through the roof to fund new social programs like Medicare and to fight an on-going war in Vietnam. If that sounds familiar to you, it should.

The U.S. government is running record high deficits as a percentage of the economy in an attempt to jump start an economic recovery, fight on-going wars in Iraq and Afghanistan, fund social programs like universal health care, and reduce carbon emissions to prevent global warming. If you think that won’t sooner or later lead to high inflation, I’ve got a few bridges I’d like to sell you.

Just because long bonds have done well in the past doesn’t mean they will do well in the future. If deflation continues for some time, as many smart people think it will, long bonds will do well. But, I believe that situation will only be temporary.

When inflation kicks up, as I think it will, long bonds will be gutted.

Stocks may not do well in the short run, but they offer excellent long term protection against inflation. Stocks are also selling at historically low prices relative to bonds. Bonds are now priced for perfection (low or declining inflation) whereas stocks are priced for a sustained recession.

Stocks may under-perform bonds over the short run, but over the long run, I don’t think its even a contest–stocks will almost certainly out-perform over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Bonds aren’t as safe as they may seem

When stock markets tank, most people think, “boy do I wish I owned bonds.”

Let me make this clear–bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn’t mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you’d have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward–but those are profits you can’t eat.

So, what are the risks for bonds. The first risk is the same as for stocks–what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business’s assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what’s left, but that doesn’t mean they will get paid back in full, and it doesn’t mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn’t have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can’t go down like stocks, think again!

The price declines I referred to above would happen quickly, but you’d still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That’s true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you’d receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970’s, and they’ll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business’s assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren’t riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it’s a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.