Sunday, August 29, 2010

Are Bonds in a "Bubble"?

The latest widespread investment thesis is that bonds (fixed income) are in a bubble similar to the Nasdaq stock market in 2000 or commodities in 2007 i.e. an unsustainable price level that sooner or later will collapse.

First off, to lump all fixed income investments together as "bonds" is asinine and reveals an oversimplified bias among the pundits who hold this view. There are a large number of professional investors and amateurs actively shorting the U.S. Treasury market which *may* bias their viewpoint...

Different kinds of bonds
Bonds are delineated based on their level of risk. The "risk free" rate is defined as short-term U.S. Treasury bills (30,60,90 day) which are deemed essentially the closest electronic equivalent to cash (i.e. paper currency). Out from there, you have various maturities of Federal Government bonds up to 30 years. These bonds are deemed equally safe from a default standpoint, however, these carry duration risk also known as purchasing power risk - the risk that inflation (prices) will increase, causing the value of the bond to be reduced and inducing a capital loss. The longer the term of the bond, the more volatile the price, so 30 year bonds are much more volatile than 2 year bonds.

Meanwhile "spread product" are fixed income investments that are deemed to carry default risk, hence they typically have yields that are above Treasury yields of a similar duration hence they have a risk premium aka. "spread" over Treasuries. Spread products include Corporate bonds (both investment grade and junk bonds), Municipal bonds and Mortgage Backed Securities (MBS). To the extent that these risk spreads have been narrowing substantially over the past year, one could argue that "spread products" are in fact overvalued relative to their historic spreads over Treasuries.

This is all very academic, so far. So here is my take on things:

1) Most/all risk bonds (Corporates, Munis, MBS) ARE overvalued although I would not call it a speculative bubble, since investors are hardly frothing at the mouth when envisioning yields of 4% on their bond portfolios i.e. there is no comparison here to the Nasdaq in 2000. The reason, I believe, that these types of bonds are overvalued is because investors are shunning risk after a decade of losses from stocks, housing, commodities and therefore seeking return of capital vs. return on capital. Meanwhile, exacerbating the situation is that the average investor does not fully understand the risk apparent to these types of investments and/or may not have access to Treasury-only investments. Many company 401k (retirement) plans have very limited investment options and offer some sort of "fixed income" option that usually includes a blend of Treasuries, Corporates, Munis and MBSs. Based on my own anecdotal experience at several companies, I doubt the average retirement plan investor has access to a pure Treasury-only bond fund.

Worse yet, many retirement funds offer an enticingly safe "Money market" fund, which we have all been led to believe are cash-like investments. Here again, however, these are short-term funds that typically include a blend of Corporate and Treasury short-term bills. Back in 2008 there was a great panic over the fact that several of these "money market" funds lost money ("broke the buck") wherein the Net Asset Value (NAV) of the fund fell below the benchmark $1/share. The Federal Government stepped in to insure money market funds, to avoid panic withdrawals, however this program had limited funding and has now since expired.

To the extent that these Spread/Risk bonds are overvalued, I still think that these investments are much safer than stocks and commodities; however, in the type of deflationary collapse that I am envisioning, losses on a typical blended "fixed income" fund could exceed 50% depending on the blend of bonds in the portfolio (Treasuries v.s. risk bonds).

Are Treasuries in a Bubble?
When pundits pose the question are bonds in a bubble, they are usually referring specifically to Treasuries, which as we know have been skyrocketing in price of late (yields falling). The answer to this question is again subjective, and depends on whether or not one believes we are heading for pervasive economic/price deflation. During Japan's deflation of the past 20 years, Japanese Government 10-year bonds yields have dipped below 1% several times. By comparison, the U.S. 10-year bond currently yields 2.65% so there is potentially still a lot of room to fall. What about the massive U.S. fiscal deficit and Quantitative Easing (QE)? Here again, it's a question of timing and sequence of events. If Japanese Government bonds can yield less than 1% despite the Japanese debt being ~ 200% of GDP, then surely U.S. Government bonds could hit the same level given that U.S. public debt is "only" ~100% of GDP (depending on whose figures you use...). Meanwhile inflation is quiescent and trending down, despite QE round 1. In addition, in a flight to quality scenario we should expect the dollar to strengthen (as it did in 2008 and has been recently) and institutional investors to invest those dollar inflows into Treasuries.

Some (EWI and others) argue that it's better to invest in short-term Treasuries v.s. long-term due to price volatility inherent in the latter. I personally think a mix is appropriate, because similar to 2008, yields on short-term Treasuries are now approaching 0% and therefore those seeking refuge in the short end of the curve will soon have the distinct pleasure of paying the Government to borrow your money - i.e. rollover risk. This EWI notion that prices (inflation) will crater, the dollar will soar, but long-term Treasury yields will rise is totally speculative and ignores the direct causal connection between dollar inflows and Treasury prices. Contrary to some belief, taking $400 cash increments from an ATM machine is not an institutional option i.e. there is no other "low risk"/highly liquid option for someone moving billions of dollars around.
In addition, institutional investors who are paid based on performance tend not to invest in non-yielding/negative yielding investments...go figure.

Ultimately, whether or not one deems Treasuries to be a "safe haven" depends on your inflationary/deflationary outlook and also the risk of the U.S. Government outright defaulting on its debt in the near-term (2-3 year) time period. I think given the proven propensity for the Federal Reserve to outright buy Treasury debt (Quanititative Easing), then the chance of default is de minimis, as all of the debt is denominated in dollars and the Fed owns the printing press. More to the point, what is the alternative? Gold perhaps is an alternative, if you believe gold prices will hold up through extreme price deflation i.e. for gold to hold its value against dollars it would actually be gaining in value relative to other commodities/assets, since in deflation by definition, the dollar would be gaining in value. I am not betting on it, but that could happen, so some amount of gold is always advisable. Another option may be Swiss Francs, however that country's banks have huge exposure to loans made to Eastern European countries.

The vast majority of ALL other types of financial assets regardless of which country, pose EXTREME LEVELS of counter-party default risk in a deflationary depression.

The other day, Jeremy Siegel, Professor of Finance at Wharton was on CNBC debating this "Are Bonds in a Bubble" issue with Tony Crescenzi of Pimco. At one point, Siegel said the dumbest and most astounding thing I have heard anyone say in the longest time, let alone a Professor of Finance. He said that investors who buy bond funds (v.s. individual bonds) in a rising interest rate environment lock in their losses permanently, because the bond fund is constantly rolling over its maturing investments i.e. the reason you buy a bond fund in the first place. Uh, repeat that please? Professor of what? The sins of stupidity here are many: First off, he didn't bother to mention that the bond fund would be rolling over at ever-higher rates of return which is what you would presumably want to do with your money as interest rates rise. Secondly, he never mentioned that ALL financial assets tend to do poorly in a high inflation environment (to wit stocks in the 1970s). Thirdly, as Tony Crescenzi all too meakly pointed out, these are mark to market investments that trade every day i.e. no one is forcing you to hold these investments forever. If you believe that interest rates are rising, then SELL NOW (i.e. reduce your duration)! His greatest failure however, especially as a Professor of Finance, was to not factor in purchasing power and opportunity cost risk, because while it's technically true that an investor who holds individual bonds (as an alternative to a bond fund) through maturity never has to realize a capital loss, so what? Garnering a 2% return for 30 years straight implies huge loss of purchasing power when the market return is 20% and inflation is running at 18%.

For those who want to protect their assets via Treasuries, the easiest way is to buy a Treasury bond mutual fund or buy the Treasury ETFs in a brokerage account. If your 401k retirement account does not offer a Treasury bond fund, then you may be able to use a "self-directed" account to buy the Treasury ETFs below. If none of these options is available, then you are still better off parked in a Money Market fund and pray Uncle Sam reinstates the insurance plan from 2008, when the shit hits the fan.

The Treasury ETFs:

SHY: 1-3 year maturities
IEI: 3-7 year (probably the best compromise between long and short-term)
IEF: 7-10 year
TLT: 20+ year (most volatile/speculative, but most upside if yields fall)

Wednesday, August 4, 2010


The specter of deflation is creeping back into the collective consciousness. I just noticed three separate articles on Yahoo discussing the various impacts of deflation on the economy. This is all right on time, because similar to 2008 pre-Lehman, the stock market has come off a retracement high, shuffled sideways for the past 3 months and should now be ready to fall off the next cliff. So, this renewed preoccupation with deflation evidences a psychological shift in mentality from reflation back to contraction, indicating we are fast approaching the next point of recognition, as it finally dawns on everyone that we are headed for a "double dip" of historic magnitude.

Price Deflation
The concept of (price) deflation is not as simple or complex as most people seem to think it is. The fact is that few of us (except my 93 year-old grandmother and others her age) have ever experienced a sustained price deflation. In order to have a sustained price deflation across ALL asset categories at the same time, requires a decrease in the supply of money. Likewise, in order to have a sustained price inflation across the board requires an increase in the supply of money. By contrast, when the price of oil goes up because the Saudis have embargoed oil exports as occurred in 1974, that in itself is not a cause of inflation (assuming no change to money supply), because the extra money used to purchase oil draws down demand from other sectors of the economy and hence lowers prices elsewhere.

Fanatical Libertarians tell us that there is nothing wrong with deflation and that all of the media hype around deflation is simply scare-mongering. Well, unfortunately these Libertarians are fantasizing about supply-side deflation resulting from a fixed money supply and increasing production efficiencies. Whereas, the type of deflation we are about to experience is a demand-side deflation wherein the price of everything drops simultaneously because there is no demand (aka. purchasing power), and where businesses go bankrupt en masse because they can't meet their fixed costs. This leads to mass unemployment and personal bankruptcy as jobs are lost, asset (home prices) crater, all the while debts (mortgages etc.) remain contractually fixed in value i.e. payments stay the same.

Credit deflation
As indicated above, credit deflation axiomatically leads to demand-side price deflation simply because there are too few dollars chasing too many goods. And despite all of the yammering and hand wringing over hyper-inflation, the Fed's unprecedented monetization of debt (~$3 trillion) has failed to yield economic reflation let alone price inflation. Credit deflation is all but inevitable now because there still exist record levels of debt (~ 4x GDP) and the renewed slowing of the economy will bring about a chain reaction of delinquencies and bankruptcies.

Just this week, the Fed announced that it is considering another round of quantitive easing (buying of debt) as a mechanism for further easing credit markets. This is an act of desperation, since the first round of debt monetization did not work, so what makes them believe this time will be different? As long as borrowers are insolvent and unable to borrow and lenders are ever-more cautious, then adding more cheap money to the pile of existing cheap money means banks will just buy up more financial assets (stocks, bonds etc.) sending yields even lower and making the inevitable market crash that much worse.

More to the point, as I explained previously here the money supply, which consists primarily of credit (loans) and to a much lesser extent currency (cash), is a giant Ponzi Scheme all of its own. And when it inevitably unwinds, it will collapse like a cheap tent at a rate that even Fed monetizing couldn't possibly offset, as there is over $50 trillion in credit outstanding (not to say that it will ALL go into default, but the largest part eventually will in my opinion).

Then there are those who believe that all of this debt is not an issue because it's largely money "we owe to ourselves" i.e. American lenders. Despite the trillions in U.S. debt owned by foreigners, it's actually true that most is held here in the U.S., to which I say "so what?" This "owe it to ourselves" argument is illustrative of the type of disinformation now commonplace in the Idiocracy. Simple reasoning shows why...

Let's say I borrow $20,000 from you - thanks buddy ! Then a year from now I've lost my job, declared bankruptcy, and unfortunately you lose the entire loan because I spent every last dime. What happens? According to the "we owe it to ourselves" morons, nothing happens - case closed. Umm, except, here is what happens in the real world: First off, I am bankrupt, so I am shut out of the credit markets - can't get a loan/credit card and my spending drops to nil. Second, the $20k of your money I spent last year was a one shot deal, so GDP was boosted by $20k last year but this year drops by that amount (think of this in the aggregate). Meanwhile, I liquidated your savings, so you too are piss broke, won't/can't spend (due to the reverse wealth effect), have lost confidence in the credit markets and are now hiding what is left of your money in the safest place possible i.e. buried in the forest. That in a nutshell is credit deflation.

The more you think about it, the more you realize it would actually be better to have all of U.S. debt owned by foreigners so that we could leave them holding the bag and not experience the adverse impacts of the reverse wealth effect. Yes, the U.S. dollar would fall relative to other currencies (although all nations will be doing their best to debase their currencies as well), but a lower U.S. dollar would: (1) improve the trade deficit (2) put China out of business (3) put WalMart out of business...i.e. the trifecta !!!

Monetary Policy No Longer Working
As I have said before, monetary policy is no longer working. Fiddle fucking with the price of money only causes the misallocation of capital and does not lead to a long term increase in economic production. It creates perpetual boom and bust cycles, and these latest grand attempts by Greenspan and Bernanke to "smoothe" the economic cycle by side-stepping recessions with ever more monetary "stimulus" just means this bust cycle will be the Mother of All Clusterfucks.

What Now?
The fact that the Fed is once again considering quantitative easing (debt monetization) emboldens my willingness to own Treasury debt of various maturities as I described here , because it's always nice to know that the Federal Reserve is the buyer of last resort for your primary assets.

In addition, until foreigners find an alternative safe haven for their trillions in assets, the dollar and hence Treasuries will continue to be the safe haven of choice and everyone can pretend for a little while longer that we are not borrowing to pay interest on prior borrowing (aka. ponzi borrowing). When we get through this deflation cycle, that will be a different story. As I've said, when you start getting a pack of crisp new $100s in the mail from the U.S. government each and every month (e.g. "Stimulus v6.0" or something like that) , then it's time to worry about inflation....