“I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”
James Carville
Tell me you watched The Crown without telling me you watched The Crown.
Anyway. As of writing, the iShares Core US Aggregate Bond ETF is down 14.4% YTD and it touched a low of -17.7% less than a month ago. Not a great result for a product that is universally considered as ‘low risk’. The S&P500 is down 16% in the same period, almost the same performance (that’s the index, if you are less lazy than me and check the returns including dividends they are probably neck-to-neck)!
Let’s stop with the premise because if you are here, you know.
For a not 100% intentional reason, I dealt with bonds for the majority of my professional career, sometimes ‘selling them’ (on the corporate side), sometimes buying them, and sometimes managing them as a capital allocator. If you read my previous posts on the UK pension funds, you know 2022 has been an even harsher year for UK bonds.
Might be a bit of Stockholm syndrome, but every time I find an article titled “would investors trust bonds ever again?” my guts twist a little. I mean…really? Are we at that point? In this post, I will recollect some concepts I already wrote about along with new considerations.
Bonds are simple
One of the main, and too often overlooked, reasons to invest in bonds is that they are very simple investment instruments (the plain vanilla ones, obviously). You know who you are lending money to, you know when and how much you are receiving back, you know where you sit in the capital structure in case of a default (there are very reliable statistics about recovery rates) and credit rating agencies even do a decent job at assessing risks on your behalf (the first that comments “Lehman Brothers was rated A days before defaulting” wins a statistic book of their choice).
Contrary to widespread urban legends, they also provide positive real returns, ie returns above inflation. This does not mean that every SINGLE year, bond returns are above that year’s inflation rate; but they do over a reasonable time horizon.
I have read many smart folks tinkering if it is reasonable to expect a safe and simple investment to provide positive real returns and I understand where they come from. It is almost too good to be true and maybe, if it is going to change in the future, we should not be that surprised. In this context, you should enjoy them while you can. Maybe it is exactly these days resurgent skepticism the factor that allows bonds to deliver positive real returns in the long run.
Traditional fixed income has become a source of unreliable volatility
This consideration is linked to the fact that many investors’ exposure to bonds is via funds/ETFs. If you buy a bond that matures in two years to match a liability, as long as that bond does not default YOUR volatility on that particular position is still zero. Yes, the price of that bond today is lower than when you bought it but…who cares, since you do not need the liquidity today. In other words, you care about the destination, not the path.
When interest rates move, a bond price loss/gain is simply a push or a pull forward of gains. When rates moved from 1% to 2%, a 7-year duration bond lost c7%. If that bond had a coupon of 1% and it was bought at par (price=100), the investor is still going to earn 1%/year. That 7% loss will reduce in the next 7 years to zero. This is a key difference with stocks. If you bought Amazon and now your position is in a 7% drawdown, you might expect that the stock will recover but, as they say, you need other buyers for that to happen, to prop the price up. You can rely on the stock dividend, if they pay one, but dividends tend to change all the time, there is no ‘contractual obligation’ for the company to keep that dividend in the future.
The real question might be: did you really want to buy that 0.5% paying bond with maturity a 10-year maturity? Were you fine to get 0.5% for the next ten years? Looking at where interest rates are today, the reply might seem a resounding no. But remember all the other predictions that were made in the recent, and not so recent, past: QE will create inflation, gold will increase with inflation and the USD will go to zero. Hindsight is always 20-20.
This year’s volatility is linked to two fundamental factors: starting interest rates were really low and they grew fast (as Cem Karsan reminded us on the latest TopTradersUnplugged podcast, still not as fast as they did in the 70s). If anything, future volatility should be lower, only by the fact that IR is now 4% and there is only so far Central Banks can push them before breaking everything.
Bond funds (except those that target a specific maturity) act differently from single bonds because they constantly reset their duration: an intermediate duration fund manages its allocation so that the overall portfolio duration is within that target (almost) every day. Single bonds within the fund still drift toward par but the fund’s constant position reshuffle makes the link between today’s P&L and the fund Yield-To-Maturity more complicated to understand. I personally consider funds the best vehicle to get bond exposure because of the diversification they offer; but if volatility is an issue for you, single bonds or target maturity funds will definitely provide more peace of mind.
Active vs Passive
Little aside. If market capitalization is a stupid way to build a stock portfolio, bond indexes are constructed in an even weirder way. For example, the amount outstanding is one of the components considered: in a way, this makes indexes more exposed to entities that are more indebted…not exactly what I would desire…
That said, I still have to find a manager that constantly beat the market. Even when the market is so (apparently) tilted to failure.
Ain’t no hedge with positive carry
Here I am stealing (what a surprise!) from Jason and Corey. In the last 40 years, bonds have been the perfect complement to stocks, their price rising when stocks were falling. All of this while paying bondholders interest. This is like if your car insurance is coverage for your vehicle repairs while also paying you an annual premium…too good to be true? Yes.
If we go back to the four-quadrant framework, is not that bonds behaved according to a new and more profitable paradigm. We simply spent 40 years bouncing between Quadrant 1 and Quadrant 4:
Removing bonds from your portfolio simply because we are now living on the right-hand side of the above graph does not sound that smart. Unless you have a framework, like this Verdad model that I already presented in the past, that tells you in which quadrant we are (or aims to ;)) and consequently how to tilt your portfolio holdings. If you have to “sin”, change your asset allocation, at least do it within a rule-based framework (ideally a framework that was designed BEFORE the event occurred and not as a reaction to something).
What’s the alternative?
As the above point suggests, the sensible alternative would be to move from the 60/40 to a more All Weather-ish portfolio. The issue with this solution is that forward returns would be most likely lower compared to what the 60/40 delivered in the past 40 years excluding 2022 (particularly in real terms). They will be higher than 60/40, especially if we include 2022, but if the investor is anchored to past figures, I foresee plenty of disappointments. If you FIREd yourself planning to live out of your portfolio generating 4 or 5% real returns…it’s time to polish that cv.
As I said, this would be the sensible alternative.
What I read more frequently is investors moving 100% out of bonds to embrace the new kid on the block, trend following. Trend following is a great addition to the all-weather portfolio but going from 60 stocks 40 bonds to 60 stocks 40 DBMF is a mistake. Not only because when the economy will move again in another quadrant you would also be in the same situation as now. But also because any trend-following instrument is waaaaaay less transparent than bonds.
Trend following is a very simple strategy but it can be implemented in thousand different ways. Outside the pure TF signal themselves, each fund’s performance depends on how many markets are traded, how much diversification they provide, how the fund manages position sizing, and so on. And each fund strategy is not static but can also vary through time, truly meaning that past performance might not be a guide for the future. Imagine being down 20% and having absolutely no clue what exactly drove that result and, more relevant, what can bring the fund back in the green.
DBMF is even more complicated than that, since they try to replicate CTA strategies just by looking at their past performance (or at least that’s what I understood). There’s someone on Twitter that is monitoring their holdings (anyone can do this, it is an ETF so they have to be transparent) and effectively confirmed that, even if they trade different markets, they have just a big, correlated risk position: long USD, long oil, short bonds and short equities might look like 4 different trades but they are all linked to the same risk…and therefore they all move together. Not a lot of ‘real’ diversification here.
If you want to have exposure to bonds, a single ETF from Vanguard or BlackRock can do the trick. If you want to have exposure to TF, for the above reasons you need more providers. It is not the end of the world and you should definitively have part of your portfolio in trend following (NOT INVESTMENT ADVICE!) but…it is not as easy as the bond sleeve to implement and understand. If in investing the noise-to-signal ratio is high, adding TF is only making the picture messier.
It was great to live in the 60/40 world because of how simple life was but, as they say, all good things come to an end.
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