“Investors Flee Bond Funds.”
“Bond Funds Take a Beating.”
“Abandoning Ship on Bonds.”
These recent headlines from the likes of The Wall Street Journal and Barron’s reflect a dim and protracted period in fixed-income investing. What’s worse is that the effect of such cheerless news is the likelihood of more of the same. Investors are chronically backward looking, and after a loss of wealth they reflexively become more interested in stopping the bleeding and licking their wounds than in fighting the next battle.
But I will here take the liberty of inverting the proverb, “What goes up must come down.” History informs that asset prices are cyclical, and indeed what goes down must eventually go up. And so they have, at least a bit, in the case of bond prices over the past few weeks.
The question is whether bonds, after having just completed (according to a consensus of well-enough respected commentators) a 30-year bull market, are at the apogee of the inevitable cycle. The response from this quarter is no. Instead, it would appear that a range-bound period is in store for at least the next year or two. This is the product of an economy that simply can’t seem to generate much momentum and, thereby, a likely continuation of the Federal Reserve’s stimulatory tonic, despite Chairman Bernanke’s recent and ever so tentative indications otherwise.
Notwithstanding his June 19 remarks, even with so-called tapering in prospect the Fed is unlikely to significantly withdraw its tried-but-so-far-untrue prescription very soon. Someday it will have to do so, or else it’s going to own all of the bonds. But nearly two years after the Fed’s first dose of quantitative easing, the patient remains in critical condition. With every somewhat positive report on housing, consumer confidence or unemployment comes swiftly on its heels an opposing report that restores gloom.
QE, reduced or not, will thus remain a part of our vernacular for the foreseeable future, meaning at least another year or two. This means a continuation of infinitesimal bond yields, but it doesn’t have to mean a continuation of wound licking. Of course, if you prefer to pout, that’s entirely your business, but it’s not an optimal behavior for an investor. Moreover, it’s illogical, because ostensibly low returns must be understood within a broader economic context.
Look, the stock market is up more than 23% over the past year, as measured by the Standard & Poor’s 500 Index. That’s great, but it’s extraordinarily abnormal. The average annual historical return is variously cited as somewhere around 10%, depending on which expert you reference. Much of the current generation of investors has never experienced a serious, several-years-long bear market. If they decide to believe my assertion that 23% is, indeed, abnormal, then they can only reluctantly accept that in any given year the market could do less than the historical average of about 10%.
They would be wrong. The market can return, and often has returned, much less than 10%. Truly seasoned investors know this, but given the euphoric past 12 months, even they can be disappointed.
Recent forecasts like Pimco’s much publicized and debated “New Normal” theory would have us accept that the near-term outlook, while not cataclysmically bleak, is dismaying. Certainly, in the context of double-digit-return expectations that is quite true. Hence, a new normal. Now, not everyone concurs with Pimco, and that’s to be expected as there are usually more market observers who are optimists rather than pessimists. It’s better for nearly every corner of the investment business that the market is forecasted to go up, and so it almost always is.
Thus, it becomes a rather simple matter of deciding to believe that asset prices will rise in accordance with Old Normal patterns because: a) QE will, as it has in the recent past, continue to prop them up, or b) the economy, as an eventual result of QE, will support them, or deciding to believe that mere single-digit returns should be expected because the Fed’s injection of liquidity and the decades-long leveraging of the world economy has inflicted damage that can only be reconciled over a very long period of time.
Irrespective of any tapering, QE will largely continue until the Fed’s targets are met: 6.5% unemployment with a 2.5% limit on inflation. There’s no sign that that’s going to happen soon, meaning low bond returns will stay with us for a long while. (It might, however, mean a decent outlook for equities, but are you really going to load up on stocks after a 23%, 12-month, artificially-juiced gain? Not me).
We are thus reduced to more of the same: paltry, nominal fixed-income returns. But what’s so bad about that? The essence of investing is “real return,” i.e., the amount by which you beat inflation, and that’s a slam dunk right now. The 10-year Treasury is yielding about 2.2% today, with inflation (as measured by the April number) at just 1.1%. That’s a 100% spread, very much in line with recent history.
To illustrate, in 1990, the 10-year vs. inflation spread was 58%, in 1995 it was 135%, and in 2000 it was 77%.
If you want to consider more risk to an appropriate portion of your bond portfolio, take a look at DoubleLine’s Opportunistic Credit Fund (DBL), a closed-end fund yielding close to 8%, Pimco’s Income Strategy Fund II (PFN), another closed-end fund yielding almost 9%, or the Stable High Yield portfolio that I manage at Covestor.com. Although Stable High Yield was adversely affected by the price decline of mortgage real estate investment trusts over the past year, since its inception on July 7, 2011, the investment has achieved an annualized return of 8.5%.
Nominal fixed-income returns may not seem like much today, but it’s a relative matter. Besides, the compelling reason to hold bonds, especially when a bond bull market is next to impossible, is to preserve capital. If you can do that and still beat inflation, you’ve been successful in an era like this one.
Disclosure: The Stable High Yield portfolio, managed by the author, is long PFN. The opinions and views expressed herein are of the portfolio manager. The opinions expressed are not intended to be relied upon as a factual prediction or forecast of future performance. Any statistics have been obtained from sources believed to be reliable. The information contained should not be used as the sole basis to make investment decisions.
The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
