Bonds !!!

[vand]

Some good discussion above.

The great problem that I see is is that as debt across public, corporate and household sectors all ballooned last year, so if we go back to the same level of interest rates as before, the overall cost of maintaining (never mind repaying) the debt will be proportionally greater.  The economy gears itself on more and more borrowing as rates go lower and lower, and unless debt is actually repaid then it traps you into an economy that cannot withstand higher rates because of its indebtedness.

Last time the stock market was this expensive the US was fundamentally in pretty good shape, with debt/GDP below 40% and coming off a couple of years where the Clinton administration actually managed to run small budget surpluses.  Today debt/GDP stands at 140%

When your debt is 40% then it costs you 2% of GDP to service your debt at 5% interest rates - this is traditionall the sort of level that developed economies have been pegged at. By contrast when your debt/GDP is 140% then you need interest rates to be 1.45% to keep your debt servicing costs below 2% of GDP. When rates start going higher then the numbers go south quite quickly.

And the US hasn't even managed to run anything resembling a balance budget since Clinton - it needs to issue more debt just to pay off existing interest, and the deficit is only increasing.

So maybe, as well as signalling rising inflation expectations (which I agree with), the move higher in rates is the market also indicating that we are beginning to explore the limits of what investors will allow governments to borrow without demanding a higher risk premium.

[MustacheAndaHalf]

Bonds generally suffer under rising interest rates

Bonds always suffer under rising interest rates everything else being equal (i.e. credit spreads unchanged)

As an investment, the bond's yield may be more significant than the capital loss caused by an interest rate increase.  The slower the interest rate increase, and shorter the term of the bond, the less likely interest rates will show an impact.

since the latest bonds have better yields than older bonds.

Nope, the yields tend to be pretty similar for similar maturities for the same issuer. Older bonds have higher coupons, but since they have that you also have to pay a lot more to buy them so if you buy an old treasury paying a 5% coupon your yield is much lower as it will trade at a premium.

Rising interest rates mean new bonds have higher coupons than old bonds.  How can rising interest rates mean "Older bonds have higher coupons"?

The new bonds have higher yields than the older bonds did.  I am comparing two points in time, like 6 months ago 30 year treasuries with today's treasuries.  When issued, the older bonds might yield 1.5%.  New bonds yield 2.0% because yields and interest rates are rising.  I agree the older bonds then adjust, by losing value until they are comparable to 2.0% yielding treasuries.

A person who just invested in treasuries has a better return than someone who invested a few months ago at lower yields.  The process of making the bonds comparable causes the older bonds to lose value.

[MustacheAndaHalf]

According to the Federal Reserve Bank of St Louis ("FRED"), from Q1 2020 to Q2 2020 the U.S. went from 108% debt/GDP to 140%.  The last update I see is 127% for Q3 2020, but I expect the $1.9 trillion stimulus to have an impact when Q1 2021 numbers come out later this year.
https://fred.stlouisfed.org/series/GFDEGDQ188S

From 1991-2021 on that graph, the lowest level seems to be 54% debt/GDP right before the dot-com bubble burst.  Ranking a list of countries by debt/GDP puts the U.S. 6th worst in the list of 199 countries on wikipedia.  The #3, #4, #5 countries are Greece, Italy, Lebanon... so not good company to be in.
https://en.wikipedia.org/wiki/List_of_countries_by_public_debt

[habanero]

Rising interest rates mean new bonds have higher coupons than old bonds.  How can rising interest rates mean "Older bonds have higher coupons"?

Because interest rates have been much higher earlier despite the recent rise in rates. If you want to invest say around the 5ypoint in treasuries you can buy the most recently issued 5y note, you can buy a 30y bond issued 25 years ago, a 10y note issued 5 years ago and so on. Depending on exactly which bond you buy their coupons can differ a lot, but the yields will be pretty similar for a given remaining maturity as you will have to pay a steep premium for the high-coupon ones and you will get the lower-coupon ones at a discount. As these bonds have different characteristics with different duration the sensitivity to interest rates will differ.

I don't think we really disagree on anything, just how long ago "earlier" is.

[tooqk4u22]

When your debt is 40% then it costs you 2% of GDP to service your debt at 5% interest rates - this is traditionall the sort of level that developed economies have been pegged at. By contrast when your debt/GDP is 140% then you need interest rates to be 1.45% to keep your debt servicing costs below 2% of GDP. When rates start going higher then the numbers go south quite quickly.

This is a notable point, especially considering that the federal government has mostly been issuing t-bills and bonds with shorter maturities - and that is the ONLY reason why the Fed and Treasury can get up there and say see  -  a shit ton of money was put in the system and our interest expense actually went down!  Sure it does, when all is issued and maturities are refinanced with 364 day notes at historically low rates.   Very little 30 years issued because we can't afford it. 

[MustacheAndaHalf]

habanero - I see why we're talking past each other.  You're talking about actual interest rates from 2019 vs now, while I'm talking about a time frame where interest rates start low and go higher.

Most people buy bond funds, instead of bonds, and I think you'd agree bond funds are impacted to the inverse of their duration.  Vanguard's Total Bond ETF (BND) has a duration of 6.6 years, so a 0.5% increase in yields (across all maturities) should cause a -3.3% change in BND's value.  They take a capital loss when interest rates rise.
https://investor.vanguard.com/etf/profile/portfolio/bnd


tooqk4u22 - Where can I learn more about the distribution of treasuries issued in 2020?  I guess it makes sense 30 year treasuries weren't popular when they paid around 1%.

[ChpBstrd]

When your debt is 40% then it costs you 2% of GDP to service your debt at 5% interest rates - this is traditionall the sort of level that developed economies have been pegged at. By contrast when your debt/GDP is 140% then you need interest rates to be 1.45% to keep your debt servicing costs below 2% of GDP. When rates start going higher then the numbers go south quite quickly.

It’s a given that higher interest rates would demolish the US economy. There’s also a case to be made that higher rates would feed upon themselves as investments in the US economy would get riskier and riskier as interest rates went up, causing investors to demand higher risk premiums, which cause higher interest rates. A scenario previously visited by Greece, Italy, and Argentina would ensue.

The question then, is whether the US government can prevent this outcome by keeping rates low indefinitely. So far, the Fed has been winning, and in the process building a huge war chest of assets that can be sold off on short notice to quash any idea of inflation. Investors say “don’t fight the Fed”. I bet the Fed will keep on winning at its new unofficial mandate to keep rates low.

Permanently low rates in the US set the stage for China or India to open their economies, float the world’s new reserve currencies, and capture a greater share of worldwide investment flows. Imagine if you could borrow USD for 2% and invest in the digital Yuan at a Chinese bank paying 5%. This would be the reverse story of how the US became so prosperous after WW2, wouldn’t it?

IDK if any other countries are actually in a position, politically, to capitalize on the opportunity, but it is there.

[MustacheAndaHalf]

It’s a given that higher interest rates would demolish the US economy. There’s also a case to be made that higher rates would feed upon themselves as investments in the US economy would get riskier and riskier as interest rates went up, causing investors to demand higher risk premiums, which cause higher interest rates. A scenario previously visited by Greece, Italy, and Argentina would ensue.

And the U.S., back in the 1980s, which reinforces your point:
https://en.wikipedia.org/wiki/Early_1980s_recession
"The sharp rise in oil prices pushed the already high rates of inflation in several major advanced countries to new double-digit highs, with countries such as the United States, Canada, West Germany, Italy, the United Kingdom and Japan tightening their monetary policies by increasing interest rates in order control the inflation"
"Most of these countries experienced stagflation, a situation of both high interest rates and high unemployment rates."

I bet the Fed will keep on winning at its new unofficial mandate to keep rates low.

I think the Fed plans to let inflation run higher than it's 2% goal for a time, so that average inflation hits it's goal.  I don't know if they'll succeed, but:

https://www.cnbc.com/2021/01/27/fed-decision-january-2021-rates-unchanged.html
"In recent months, officials have made their commitment to low rates even more aggressive, vowing not to start hiking even if inflation gets close to or slightly exceeds the central bank’s 2% target."

[vand]

When your debt is 40% then it costs you 2% of GDP to service your debt at 5% interest rates - this is traditionall the sort of level that developed economies have been pegged at. By contrast when your debt/GDP is 140% then you need interest rates to be 1.45% to keep your debt servicing costs below 2% of GDP. When rates start going higher then the numbers go south quite quickly.

It’s a given that higher interest rates would demolish the US economy. There’s also a case to be made that higher rates would feed upon themselves as investments in the US economy would get riskier and riskier as interest rates went up, causing investors to demand higher risk premiums, which cause higher interest rates. A scenario previously visited by Greece, Italy, and Argentina would ensue.

The question then, is whether the US government can prevent this outcome by keeping rates low indefinitely. So far, the Fed has been winning, and in the process building a huge war chest of assets that can be sold off on short notice to quash any idea of inflation. Investors say “don’t fight the Fed”. I bet the Fed will keep on winning at its new unofficial mandate to keep rates low.

Permanently low rates in the US set the stage for China or India to open their economies, float the world’s new reserve currencies, and capture a greater share of worldwide investment flows. Imagine if you could borrow USD for 2% and invest in the digital Yuan at a Chinese bank paying 5%. This would be the reverse story of how the US became so prosperous after WW2, wouldn’t it?

IDK if any other countries are actually in a position, politically, to capitalize on the opportunity, but it is there.

Absolutely agreed with this.

So far Fed policy has been so successful because the lack of inflation allows them to print as much currency as they need to in order to support the economy and financial system.  However if and when inflation starts to rear its head this removes their favourite tools, and they are forced to tighten monetary policy in order to fight inflation.  There can be a reflexive loop as lower/negative growth means investors have less faith in the government's ability to meet its obligations, so they are less willing to buy its debt, making it more expensive to borrow, further hindering growth, which further eroding investors' faith, so they demand even higher rates of return etc.

Again, there is really nothing new here and we've seen it before, but certainly not for a very long time in the US, such that most people will have no memory of the last time the Fed was backed into this corner.

[vand]

For context, this time last year it was:
10y: 1.56%
30y: 2.01%

Of course, by then the early warnings about Covid were starting to be digested, so looking at Jan 2, 2020 rates were:
10y: 1.88%
30y: 2.33%

The yield curve is is steepening, so one way to play it could be to buy banks and financial stocks. Indeed the sector has seen some pretty good performance in the last few months, and I notice that today they're doing quite well comparatively when the rest of the broader market is down.  This might be one of the less-dumb ways of "owning" inflation.

[CrankAddict]

This thread is making my head hurt.  So as the representative idiot here, I've plodded along for 20+ years with this crude understanding that "bonds are safe but aren't going to wow you with returns" and "stocks have potential to make more money but it's going to be a rocky ride".  You can go to Vanguard today and in their investing advice page it shows "conservative" = 70% bond, 30% stock,  "moderate" = 50/50 and "aggressive" = 70% stock, 30% bond.  This is inline with what I understood.  As a result for quite some time I was 70/30 VTSAX/VBTLX and then in December I went to 55/45 over a general feeling of uncertainly and lack of faith in half a dozens aspects of our national and global situation.  I'm currently trying to decide what AA to move to again for the longer term but when I read this thread it basically sounds like the opposite of all I thought I knew.  It sounds like bonds should be named "bombs" and if I really wanted to be conservative I'd get rid of these things asap. 

Do these bond risks apply as much to bond funds such as VBTLX?  My (limited) understanding is that if I bought myself actual bonds today and then tomorrow interest rates increase, my bonds will be worth less because tomorrow's bonds will pay a higher return to match higher rates.  My bonds from today will be less appealing.  But with bond funds, how does this work?  There's only 1 price for VBTLX.  How can that be?  If I bought it 5 years ago wouldn't it be holding bonds that have a different yield than if I bought it today?  I must be missing something fundamental.  And to be honest I'm not sure I need to understand all the mechanics, but more just the high level question of whether a bond fund can still be used the way I've always thought it could be.

[ChpBstrd]

This thread is making my head hurt.  So as the representative idiot here, I've plodded along for 20+ years with this crude understanding that "bonds are safe but aren't going to wow you with returns" and "stocks have potential to make more money but it's going to be a rocky ride".  You can go to Vanguard today and in their investing advice page it shows "conservative" = 70% bond, 30% stock,  "moderate" = 50/50 and "aggressive" = 70% stock, 30% bond.  This is inline with what I understood.  As a result for quite some time I was 70/30 VTSAX/VBTLX and then in December I went to 55/45 over a general feeling of uncertainly and lack of faith in half a dozens aspects of our national and global situation.  I'm currently trying to decide what AA to move to again for the longer term but when I read this thread it basically sounds like the opposite of all I thought I knew.  It sounds like bonds should be named "bombs" and if I really wanted to be conservative I'd get rid of these things asap. 

Do these bond risks apply as much to bond funds such as VBTLX?  My (limited) understanding is that if I bought myself actual bonds today and then tomorrow interest rates increase, my bonds will be worth less because tomorrow's bonds will pay a higher yield to match higher rates.  My bonds from today will be less appealing.  But with bond funds, how does this work?  There's only 1 price for VBTLX.  How can that be?  If I bought it 5 years ago wouldn't it be holding bonds that have a different yield than if I bought it today?  I must be missing something fundamental.  And to be honest I'm not sure I need to understand all the mechanics, but more just the high level question of whether a bond fund can still be used the way I've always thought it could be.

Yes, bonds could tank in a surprising way if interest rates rise. That has always been the case, but the effect is magnified due to "bond convexity" which is to say bonds are more sensitive to interest rate changes at very low interest rates like we have now. You can create your own rough models in Excel using the PV function. Flip through different interest rates and durations to assess the potential for damage. That said, stocks will probably do worse than bonds in any inflationary scenario.

To really get low-risk, one must get into hedging strategies using options IMO.

Bond funds are constantly trading and churning their bonds, trying to maintain an average duration, interest rate sensitivity, ratings, or index exposure. Thus their performance will differ from a single bond, bought and held. The single bond is constantly changing its duration and interest rate sensitivity, and sometimes the rating changes too.

[CrankAddict]

Yes, bonds could tank in a surprising way if interest rates rise. That has always been the case, but the effect is magnified due to "bond convexity" which is to say bonds are more sensitive to interest rate changes at very low interest rates like we have now.

Didn't realize it was non-linear in some way, good to know.

Bond funds are constantly trading and churning their bonds, trying to maintain an average duration, interest rate sensitivity, ratings, or index exposure. Thus their performance will differ from a single bond, bought and held. The single bond is constantly changing its duration and interest rate sensitivity, and sometimes the rating changes too.

So am I wrong to conclude that bond funds are designed to be interest rate INsensitive as much as possible?

[vand]

https://www.blackrock.com/us/individual/education/understanding-duration

"As a general rule, for every 1% increase or decrease in interest rates, a bond's price will change approximately 1% in the opposite direction for every year of duration."

For reference, the TLT bond fund (20+yr maturity) has a duration of almost 19yrs, so a 1% change in long term rates would move the fund 19% in the other direction, and the US 30yr note has a duration of about 21yrs.

So you can see how sensitive long bond funds are to a rise in long term rates - they are certainly not "safe" if by safe you mean you can't lose real money (ie purchasing power) with them over either short or long holding periods. They are only considered safe in that theoretically the issuer has a printing press and so never needs to hard default on them.

[ChpBstrd]

So am I wrong to conclude that bond funds are designed to be interest rate INsensitive as much as possible?

Short durations have low sensitivity. Long durations have high sensitivity.

A short-duration fund like BSV will naturally be less sensitive to changes in interest rates than a long-duration fund like TLT. Long duration typically has a higher yield than low duration because investors must be compensated for the added risk.

Funds have to pick a duration to buy anything, and thus they have to pick an interest rate sensitivity. Some actively-managed funds might incorporate hedges against interest rate increases (swaps, futures, options...) but with today's yields so low, I doubt they have much to work with, because the cost of such hedges would have to come out of the already-puny yield.

[vand]

https://theirrelevantinvestor.com/2021/02/16/bonds-are-getting-crushed/

Good chart this, show how credit spreads are widening. This is good, to an extent, for financials.. and bad for high p/e bubble stocks.


ZROZ ouch:

[MustacheAndaHalf]

So am I wrong to conclude that bond funds are designed to be interest rate INsensitive as much as possible?

Vanguard long-term treasury bond fund had -9.37% performance year to date.  Their short-term treasury bond fund was just -0.16% year to date.
https://investor.vanguard.com/mutual-funds/profile/performance/vustx
https://investor.vanguard.com/mutual-funds/profile/performance/vfisx

[vand]

A big jump in the yield on the US 10y note today, which is now within a whisker of touching 1.5%.. that's a very important psychological level. 

Bonds are begin to look a whiff more attractive at these levels. I mean, this is still more about return of capital rather than return on capital, but there actually a decent chance that the 10y note will beat inflation over the next decade, and it is not outside of the realms of possibility that from these relative levels, US fixed income could also outperform US equities over the next decade.

[CrankAddict]

A big jump in the yield on the US 10y note today, which is now within a whisker of touching 1.5%.. that's a very important psychological level. 

Bonds are begin to look a whiff more attractive at these levels. I mean, this is still more about return of capital rather than return on capital, but there actually a decent chance that the 10y note will beat inflation over the next decade, and it is not outside of the realms of possibility that from these relative levels, US fixed income could also outperform US equities over the next decade.

Sorry to keep asking dumb questions, but I'm getting the sense that the recent shifts in the bond market are in the direction of new/future bonds looking more attractive (i.e. higher returns).   But in turn this is a bad thing for anyone holding existing bonds since those get de-valued due to them being less attractive than the new/future ones.  Is that correct?  If so that's sort of an odd paradigm where bonds as an asset are becoming stronger yet this is undesirable to existing owners of the asset.

[ChpBstrd]

A big jump in the yield on the US 10y note today, which is now within a whisker of touching 1.5%.. that's a very important psychological level. 

Bonds are begin to look a whiff more attractive at these levels. I mean, this is still more about return of capital rather than return on capital, but there actually a decent chance that the 10y note will beat inflation over the next decade, and it is not outside of the realms of possibility that from these relative levels, US fixed income could also outperform US equities over the next decade.

Sorry to keep asking dumb questions, but I'm getting the sense that the recent shifts in the bond market are in the direction of new/future bonds looking more attractive (i.e. higher returns).   But in turn this is a bad thing for anyone holding existing bonds since those get de-valued due to them being less attractive than the new/future ones.  Is that correct?  If so that's sort of an odd paradigm where bonds as an asset are becoming stronger yet this is undesirable to existing owners of the asset.

Yes. Nobody is going to buy your bond yielding 1% when they could buy a similar bond yielding 1.5%, so to sell it you'd have to make your old bond yield 1.5% for the buyer by cutting the price they have to pay for it. Thus the market price of old bonds falls when the yield offered by new bonds rises. Sellers of old bonds have to cut their price until the yield is competitive.

The process works in reverse too. If you buy a bond yielding 2% and the market yield drops to 1%, you can raise the asking price on your bond until it effectively yields 1%.

The PV function in Excel can be used to simulate bond losses due to rising rates.

[vand]

Bond bloodbath in progress?

At this juncture, the bond market is raising some important questions

- Risk premia across most other asset classes is getting narrowed, making harder to justify riskier assets. Equities have to justify higher expected returns to keep them attractive

- what will it mean for 60/40 portfolios? Investors with classic portfolios would have accepted softening in bonds as long as stocks were doing a moonshoot over the last few months, but now we have selloffs in both asset classes.. this isn't how it was meant to work.

- What is the chance that bonds will outperform stocks over the next decade? Last summer with yields at 0.5% and stocks still in recovery mode I would have said no chance, but today with stocks now looking horribly expensive and bonds offering 1.5% the chances of that must have risen from the <5% possibility to at least >25% possibility, and maybe even higher than that.

- Is inflation really about to make a comeback? We've all been conditioned in a disinflationary environment for so long now that it it will undoubtedly come as a shock to most people when the price of living starts increasing more noticeably year on year.

- How will the balance between growth and value stocks change? Everything suggests that in a world where the far end of the yield curve is steepening most quickly, then projects with long lead times will be the most sensitive to those changes (ie growth stocks).

2021 is shaping up to be an interesting year..

[ChpBstrd]

- What is the chance that bonds will outperform stocks over the next decade? Last summer with yields at 0.5% and stocks still in recovery mode I would have said no chance, but today with stocks now looking horribly expensive and bonds offering 1.5% the chances of that must have risen from the <5% possibility to at least >25% possibility, and maybe even higher than that.

The S&P500's current trailing 12 months PE ratio of ~45 makes stocks look grotesquely overpriced. However, those 12 months included a severe recession. Forward estimates are around 22. It was confusing to evaluate stocks in 2009/2010 too.
https://www.wsj.com/market-data/stocks/peyields

- Is inflation really about to make a comeback? We've all been conditioned in a disinflationary environment for so long now that it it will undoubtedly come as a shock to most people when the price of living starts increasing more noticeably year on year.

I see current rates as a reversion to pre-pandemic levels. The market is watching COVID cases plummet and vaccines going into millions of arms, and thinking "wait, why haven't interest rates returned to pre-pandemic levels!" I don't see 1.38% 10-year yields as a trend that will continue forever or a sign of imminent inflation, just like I didn't think 2% 10-year treasury yields were indicating high inflation back in 2019. Sure, shorting TLT might be a trade that still has legs, but for actual inflation to occur something structural would have to change (demographics, reserve currency, remittances, trade deficits, etc.).

- How will the balance between growth and value stocks change? Everything suggests that in a world where the far end of the yield curve is steepening most quickly, then projects with long lead times will be the most sensitive to those changes (ie growth stocks).

Here is an article you might enjoy about the rationale stated here. The conclusion is that value will outperform if rates go up, because cash flows in the near future will suffer less of a discount than the distant cash flows of growth companies. 
https://seekingalpha.com/article/4408938-bubble-burst-might-already-be-reits-are-safe-haven
I think this is more a case to be in low-leverage value stocks rather than highly leveraged REITs as the author calls for.

[tooqk4u22]

Bond bloodbath in progress?

I wouldn't call it a bloodbath, at least not overall.  Sure in long term bonds, like TLT, but not the rest.  BND is down maybe 4% from peak - not horrible.  But this is the problem when you have fed/treasury manipulation - historically non-correlated assets become very correlated. 

10 year treasury "should' be at 2-2.5% right now given where inflation is.   

[MustacheAndaHalf]

The S&P500's current trailing 12 months PE ratio of ~45 makes stocks look grotesquely overpriced. However, those 12 months included a severe recession. Forward estimates are around 22. It was confusing to evaluate stocks in 2009/2010 too.

It's so nice to see data given with context!

I returned to small/value to profit off their recovery.  The 1 year performance (+49%) of RZV (one I hold) leaves out the losses that had already occurred a year ago, so the 2 year performance of +16% is probably more useful.  I'm not sure how well small/value will do after the recovery, so I plan to sell before then.

I don't have good information showing that bank stocks will benefit during the recovery and afterwards, but rising interest rates help them.  So another option could be bank stocks.  (Note that I'm biased: a bank ETF is my biggest holding at IBKR).

"Bank stocks have “moved back into vogue” due to optimism about fiscal stimulus, infrastructure spending, rising interest rates and bigger capital returns, Goldman analyst Richard Ramsden wrote last week"
https://www.bloomberg.com/news/articles/2021-01-10/bank-stocks-are-back-in-vogue-on-stimulus-interest-rate-outlook

[CrankAddict]

I'm finding it hard to understand the idea that somebody who was heavily in stocks would now think "oh, I can get 1.5% from bonds? I'm in!".  If bonds were paying 6% or 8%, sure, I could see them siphoning a lot more folks.  But 1.5% seems like it would only attract the "I made a bunch of funny money on these over-priced stocks, time to get out before this timebomb explodes" crowd, and even for them it would be a short term layover.  You don't just go from enjoying 15% returns to being content with 1.5%.  Regardless, anybody following the "stick to the plan, buy every paycheck, don't try to time the market" mantra wouldn't even consider such a move, right?  I guess I'm still struggling to understand what the big deal is here.  Is this possibly just the financial press turning everything into "breaking news"?

[ChpBstrd]

I see current rates as a reversion to pre-pandemic levels. The market is watching COVID cases plummet and vaccines going into millions of arms, and thinking "wait, why haven't interest rates returned to pre-pandemic levels!" I don't see 1.38% 10-year yields as a trend that will continue forever or a sign of imminent inflation, just like I didn't think 2% 10-year treasury yields were indicating high inflation back in 2019. Sure, shorting TLT might be a trade that still has legs, but for actual inflation to occur something structural would have to change (demographics, reserve currency, remittances, trade deficits, etc.).

I'm trying to enter a bear put spread on TLT at the 148 and 149 strikes, with a few hundred bucks. This is a bet on interest rates reverting to the ~2% levels seen in 2019, as pandemic panic fades from the bond markets. That would cause TLT to continue tanking. It's a 100% profit or 100% loss proposition. If any of you would like to make the opposite bet, please sell me this spread!

[vand]

I'm finding it hard to understand the idea that somebody who was heavily in stocks would now think "oh, I can get 1.5% from bonds? I'm in!".  If bonds were paying 6% or 8%, sure, I could see them siphoning a lot more folks.  But 1.5% seems like it would only attract the "I made a bunch of funny money on these over-priced stocks, time to get out before this timebomb explodes" crowd, and even for them it would be a short term layover.  You don't just go from enjoying 15% returns to being content with 1.5%.  Regardless, anybody following the "stick to the plan, buy every paycheck, don't try to time the market" mantra wouldn't even consider such a move, right?  I guess I'm still struggling to understand what the big deal is here.  Is this possibly just the financial press turning everything into "breaking news"?

Why? It's not an absolute given that US stocks will outperform the 1.5% available on bonds over the next 10 years.  Yes stocks have done stunningly well over the last 12 years, but that's all in the rear view mirror now. What it returns going forward is what matters.

Some valuation models give the US a fairly high chance of a negative real return over 10 years.

See here: https://www.gurufocus.com/stock-market-valuations.php
and here: https://alephblog.com/2020/12/10/estimating-future-stock-returns-september-2020-update/

Even if you think equities will do slightly better than some of these predictions, when you factor in the added risk in in the stocks it may be hard to justify, or at least it makes sense to hold more bonds to improve the risk profile of the portfolio.

[CrankAddict]

Even if you think equities will do slightly better than some of these predictions, when you factor in the added risk in in the stocks it may be hard to justify, or at least it makes sense to hold more bonds to improve the risk profile of the portfolio.

Point taken, but isn't this thread suggesting that bonds have a lot of potential uncertainty too?  Perhaps not if you are buying actual bonds, but rather like most of us buying bond funds, then that 1.5% is far from guaranteed, right?



Sent from my SM-G960U1 using Tapatalk

[vand]

Even if you think equities will do slightly better than some of these predictions, when you factor in the added risk in in the stocks it may be hard to justify, or at least it makes sense to hold more bonds to improve the risk profile of the portfolio.

Point taken, but isn't this thread suggesting that bonds have a lot of potential uncertainty too?  Perhaps not if you are buying actual bonds, but rather like most of us buying bond funds, then that 1.5% is far from guaranteed, right?



Sent from my SM-G960U1 using Tapatalk

They have short term volatility, the same as anything else - as ChpBstrd says, the longer the maturity the higher the duration (ie sensitivity to interest rates), however the total return if held to maturity will be very close the current yield.

[vand]

- What is the chance that bonds will outperform stocks over the next decade? Last summer with yields at 0.5% and stocks still in recovery mode I would have said no chance, but today with stocks now looking horribly expensive and bonds offering 1.5% the chances of that must have risen from the <5% possibility to at least >25% possibility, and maybe even higher than that.

The S&P500's current trailing 12 months PE ratio of ~45 makes stocks look grotesquely overpriced. However, those 12 months included a severe recession. Forward estimates are around 22. It was confusing to evaluate stocks in 2009/2010 too.
https://www.wsj.com/market-data/stocks/peyields

Yes P/E can be temporarily broken during a contraction and not reliable, but generally speaking all valuation models tell us the market is expensive.. as it should be given rates have been so low for so long.  CAPE10 sits at 36. P/B & P/Sales off the charts, Buffett indicator 190% or so.. incidentally, why has nobody done a smoothed 10 year Buffett Indicator...

[Telecaster]

They have short term volatility, the same as anything else - as ChpBstrd says, the longer the maturity the higher the duration (ie sensitivity to interest rates), however the total return if held to maturity will be very close the current yield.

And it is hard to imagine bond prices going anywhere but down. 

[vand]

Another fairly gloomy piece on Bonds from Ben Carlson:
https://awealthofcommonsense.com/2021/03/a-bleak-future-for-long-term-government-bonds/

Future returns in the bond market were all sucked forward as rates were driven down to zero. We are now firmly stuck in that future and have no more forward returns to pull into the present.

[The 585]

IPS has me sitting at 20% bonds in vanguard's total bond market. Should I be looking at alternatives for this, or "stay the course" despite such a gloomy outlook?

[vand]

IPS has me sitting at 20% bonds in vanguard's total bond market. Should I be looking at alternatives for this, or "stay the course" despite such a gloomy outlook?

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

Reading and learning as much as you can will lead to more conviction whatever you decide, which is the best defence you have against future uncertainty.

[tooqk4u22]

IPS has me sitting at 20% bonds in vanguard's total bond market. Should I be looking at alternatives for this, or "stay the course" despite such a gloomy outlook?

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

Reading and learning as much as you can will lead to more conviction whatever you decide, which is the best defence you have against future uncertainty.

Agree that only you can answer that.  But currently (and have been for a year now) oriented in short term/ultra short term/cash for my now stock AA.   Vanguards total bond isn't that bad with a duration of 6.6 years but and you see that playing out by being down about 3% YTD while 10 UST is up about 50bps.     

The TLT is far greater risk.   

[vand]

IPS has me sitting at 20% bonds in vanguard's total bond market. Should I be looking at alternatives for this, or "stay the course" despite such a gloomy outlook?

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

Reading and learning as much as you can will lead to more conviction whatever you decide, which is the best defence you have against future uncertainty.

Agree that only you can answer that.  But currently (and have been for a year now) oriented in short term/ultra short term/cash for my now stock AA.   Vanguards total bond isn't that bad with a duration of 6.6 years but and you see that playing out by being down about 3% YTD while 10 UST is up about 50bps.     

The TLT is far greater risk.

I'm about 4% long bonds, 3% medium, 3% short term & 10% cash. Short term bonds behave much more like cash than they do long term bonds..

You can also look at corporate & junk bonds which are higher risk and therefore exhibit risk-on characteristics more similar to equities.  Both have done much better than treasuries since the summer.

[CrankAddict]

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

So to that point, we have established long term bonds don't fare well in times of inflation, but is there a historical comparison to how the same inflation impacts a total stock market fund, for example?  I.e. are we hedging against inflation by moving from bonds to stocks at this point, or is that a false premise?

[vand]

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

So to that point, we have established long term bonds don't fare well in times of inflation, but is there a historical comparison to how the same inflation impacts a total stock market fund, for example?  I.e. are we hedging against inflation by moving from bonds to stocks at this point, or is that a false premise?

Depends why you mean by inflation - an inflationary spike like we saw in 2008 is different to long term secular inflation like we saw in the 1970s. The relationship between inflation and bonds is simple, because its payout rate is fixed, but equities have a more complex relationship because companies are dynamic and are able to eventually adjust to whatever prevailing economic conditions. Historically, while company earnings can tolerate a certain amount of inflation, as an asset class they tend to get de-rated when inflation climbs higher, so both bonds and equities tend to prefer disinflationary and low-inflation environments. Remember that companies also use debt, so low interest rates and cheap debt is a great advantage to them.

There is another thread about stocks and inflation here:
https://forum.mrmoneymustache.com/investor-alley/stocks-are-not-an-inflation-hedge

this report is very good at analysing how different asset classes fare in different inflationary environments:
https://www.schroders.com/en/sysglobalassets/staticfiles/schroders/sites/americas/canada/documents/investment-perspective-what-are-the-inflation-beating-asset-classes.pdf

but broadly, from best to worst:

Commodities
TIPs (maybe - not much history)
Gold (distinct from general commodities, because it behaves so differently to most other commodities)
Real estate
Equities
Fixed Income
Cash

[ChpBstrd]

No one can answer that for you, all we can do is discuss the likely expected returns and risks in long term bonds, which have to be weighed against those in other asset classes. 

So to that point, we have established long term bonds don't fare well in times of inflation, but is there a historical comparison to how the same inflation impacts a total stock market fund, for example?  I.e. are we hedging against inflation by moving from bonds to stocks at this point, or is that a false premise?

Depends why you mean by inflation - an inflationary spike like we saw in 2008 is different to long term secular inflation like we saw in the 1970s. The relationship between inflation and bonds is simple, because its payout rate is fixed, but equities have a more complex relationship because companies are dynamic and are able to eventually adjust to whatever prevailing economic conditions. Historically, while company earnings can tolerate a certain amount of inflation, as an asset class they tend to get de-rated when inflation climbs higher, so both bonds and equities tend to prefer disinflationary and low-inflation environments. Remember that companies also use debt, so low interest rates and cheap debt is a great advantage to them.

There is another thread about stocks and inflation here:
https://forum.mrmoneymustache.com/investor-alley/stocks-are-not-an-inflation-hedge

this report is very good at analysing how different asset classes fare in different inflationary environments:
https://www.schroders.com/en/sysglobalassets/staticfiles/schroders/sites/americas/canada/documents/investment-perspective-what-are-the-inflation-beating-asset-classes.pdf

but broadly, from best to worst:

Commodities
TIPs (maybe - not much history)
Gold (distinct from general commodities, because it behaves so differently to most other commodities)
Real estate
Equities
Fixed Income
Cash

Cash (e.g. 1 year bank CDs) will usually outperform fixed income (e.g. a bond with 10y duration) in an inflationary environment.

Real estate is more of a wildcard. Rising mortgage rates will, in theory, drive prices lower but higher construction costs will, in theory, drive prices higher. Mortgage rates will matter more in HCOL areas. Construction costs will matter more in LCOL areas.

[vand]

yes Cash is stable, so its real return will just be negative whatever the nominal rate of inflation is, ie the absolute rate of inflation is what is important.

Bonds with any noticeable duration will get sold off by that amount for every 1% rise in the rate of inflation, so bonds are sensitive to changes in inflation rather than the absolute rate of inflation

[CrankAddict]

I really appreciate the continued information you guys are sharing.  Just one confirmation: bonds only "dislike" an increase in inflation, not a static elevated rate, is that correct?  E.g. if interest rates rose to 10% over the next 3 years but then stayed there for a decade, bonds would be great to hold during that subsequent decade but not great to hold during the 3 years getting there.  Do I have that right?

[tooqk4u22]

I really appreciate the continued information you guys are sharing.  Just one confirmation: bonds only "dislike" an increase in inflation, not a static elevated rate, is that correct?  E.g. if interest rates rose to 10% over the next 3 years but then stayed there for a decade, bonds would be great to hold during that subsequent decade but not great to hold during the 3 years getting there.  Do I have that right?

Rates/prices are correlated but also alternative investment class.   Historically, bonds and equities were less correlated but the FED/Treasury has changed it all in the recent past and they have become more correlated, so how that works out is TBD. 

[Radagast]

Historically, bonds and equities were less correlated but the FED/Treasury has changed it all in the recent past and they have become more correlated, so how that works out is TBD.

That is not correct. From 1940-2000 bonds and stocks became increasingly correlated to the point that people seriously asked why bother with bonds at all, as they appeared to be lower return versions of stocks. 2000-2020 were actually an unusual period of strong negative correlation, unprecedented since the Great Depression and if anything stronger than then.

[vand]

I really appreciate the continued information you guys are sharing.  Just one confirmation: bonds only "dislike" an increase in inflation, not a static elevated rate, is that correct?  E.g. if interest rates rose to 10% over the next 3 years but then stayed there for a decade, bonds would be great to hold during that subsequent decade but not great to hold during the 3 years getting there.  Do I have that right?

Largely, yes.

You can see the correlation between the rate of inflation and bond yields - as inflation rises, yields move up (ie bonds go down) and vice versa. Sometimes there is a bit of a lag.  Actually you can see that in the short period after inflation peaked in 1981ish, yields continued to go higher for a year or two after. In hindsight - what a great time to be buying bonds!! (of course you have to have faith that the USD wasn't going to lose reserve currency status and become toilet paper). Depressed prices even as the fundamentals are rapidly improving is the the sort of bearishness that is often associated with the end of secular bear markets.  If we were to see the opposite today - rising bonds even as inflation is rising, that would mark the complete opposite often associated with secular bull market tops. Maybe we have already seen it? Bubbles are defined by irrationality at the top.. its completely irrational to buy a fixed income product that you believe will give you a negative real return until maturity. I dunno. interesting to mull over, isn't it?

[vand]

Yikes.
After a couple of days' respite the slide in bonds seems to be continuing.. TLT down another 2% today.
Long duration Bondholders are getting slaughtered!

10y yields up to 1.63%
30y yields up to 2.35%


Having a good understanding of the bond market improves your understanding of stocks and other assets too. They're so fundamental to the investing pyramid as they effective set the hurdle rate on all riskier assets.

[ChpBstrd]

I only wonder how did the stock market not see this coming? Better yet, how did the bond market not see it coming? Better yet, why didn't I?

[nihilism122]

Nope.

Yields are too low for me.

Agreed.  They are also taxed unfavorably, so it's the worst of both worlds.  Dividend stocks have higher yields, lower taxes, and can offer some share price appreciation as well.  I don't see any use for bonds in today's environment. 

[habanero]

I only wonder how did the stock market not see this coming? Better yet, how did the bond market not see it coming? Better yet, why didn't I?

It is (and was) very far from obvious that bonds had to tank. You can make an entirely plausible line of reasoning for yields going even lower than they were and staying there for a very long time or one for a violent selloff.

[vand]

I only wonder how did the stock market not see this coming? Better yet, how did the bond market not see it coming? Better yet, why didn't I?

It is (and was) very far from obvious that bonds had to tank. You can make an entirely plausible line of reasoning for yields going even lower than they were and staying there for a very long time or one for a violent selloff.

Agreed, there are no obvious gimmes when it comes to investing, especially in something as massive and liquid as public markets. Everything is obvious in hindsight, and clear as mud in the moment.

There are, however, situations where risk and reward can be judged to be quite assymetrical. These usually make the most interesting plays. I think long bonds were such an asymmetric situation when yields were on the floor last summer. We would have needed to go into a deflationary scenario for bonds to have kept rising - possible, but never likely, especially when you have a government with an unlimited printing press.

Personally I've bumped up my bond allocation slightly at these yields. Its not at all clear to me if yields will continue to spike higher, or if from here we see a retreat, at least over the short term.

[MustacheAndaHalf]

Historically, bonds and equities were less correlated but the FED/Treasury has changed it all in the recent past and they have become more correlated, so how that works out is TBD.

That is not correct. From 1940-2000 bonds and stocks became increasingly correlated to the point that people seriously asked why bother with bonds at all, as they appeared to be lower return versions of stocks. 2000-2020 were actually an unusual period of strong negative correlation, unprecedented since the Great Depression and if anything stronger than then.

That's not what the fixed income specialists at PIMCO say:

"Presumably, many believe the historically negative stock-bond correlation reflects the degree to which bonds will effectively hedge against a significant equity market sell-off, as happened in the 2008 global financial crisis."
https://global.pimco.com/en-gbl/insights/viewpoints/does-the-stock-bond-correlation-really-matter

The 1926-2019 stock/bond correlation varies from 0.07 (monthly) to 0.21 (5 year) according to this research:
https://www.statestreet.com/content/dam/statestreet/documents/Articles/Stock-bond-correlation-full-paper.pdf

So I disagree with your correction, although I'd be open to data showing the correlation is high.  For a U.S. investor, bonds provide much better diversification than international equities.  That's why traditional advice is to have a mix of stocks and bonds.