May 11th, 2015
by Lance Roberts, StreetTalk Live
This week, I received many emails about the recent uptick in rates and the corresponding impact on bond values in portfolios. I want to use this weekend's missive an educational platform for fixed income held in portfolios.
However, before we get to that, let me say a word about the recent uptick in rates. First, bonds were extremely overbought in the short-term which is why I began suggesting TAKING PROFITS in bonds, funds and related ETF's almost a month ago. The slide in bonds has been nothing more than a short-term selloff as we have repeatedly seen over the last THIRTY (30) YEARS. Let's keep a little perspective here shall we!!!!
With economic growth running at exceptionally low rates, along with depressed inflationary pressures and monetary velocity, interest rates will remain range-bound at low levels for quite some time. This is simply because interest rates are a reflection of the demand for credit over time, and in a weak economic environment higher rates cannot be sustained. The chart below shows and confirms the above.
Therefore, the recent uptick, as recommended in last weekend's newsletter, is now a buying opportunity for bonds. Use any push from current levels to as high as 2.7% to increase exposure in individual bonds that will be held until maturity and bond funds/ETF's for the next trading opportunity.
Interest Rates, Bond Values & Your Portfolio
With that stated, Let's talk about how fixed income works in a portfolio over time and an email I received last week.
"But Lance, the recent rise in interest rates has made the value of my portfolio go down."
My answer: So what?
The rise and fall of interest rates are only of concern if you own bond funds or bond related ETF's.
Bond funds and bond related ETF's (exchange traded funds) ARE NOT BONDS. Funds and ETF's are a BET on the DIRECTION of interest rates just as stocks are a bet on the direction of the market. There is no return of principal function for bond funds or bond related ETF's and, therefore, must be managed in a portfolio just as you would manage a stock position.
However, the rise and fall of interest rates is of very little concern in a portfolio of individual bonds that are being held until maturity. The only time the level of interest rates becomes of concern is when a bond owner wishes to liquidate a bond position due to changes in the borrower's fundamentals, credit worthiness or the bond owner needs to raise liquidity.
You own XYZ bond that is just 12 months from maturity. You decide that you need to buy a new home and need to liquidate some bond holdings to raise the capital for the purchase.
The prevailing "yield to maturity" for similar bonds in the market is now 6% versus the XYZ bond that is at 5%.
Question: Why would someone buy your XYZ bond when they could buy a different bond that would yield 6%?
When interest rates fluctuate, the prices of bonds must be adjusted so that their specific yields to maturity match what is available in the general market place at that given time.
(Note: This is a very basic example, and there are many other factors that affect bond prices other than just the movement of interest rates.)
Since a bond buyer is looking to buy a bond with a 6% yield to maturity, what must happen in order for him to purchase a bond with a current lower yield to maturity?
In order for the XYZ bond to have a 6% yield to maturity in the next 12 months the price of the bond must be adjusted as follows:
Face Value: $1000 Coupon: 5% or $50 Yield To Maturity: $1000 (return of principal) + $50 interest = $1050 or 5%
Note: This transaction is occurring between two individuals. XYZ has an obligation to repay $1000 at maturity to whoever is the owner of the bond at that time.
Therefore, in order to increase the yield to maturity the selling price of the bond is LOWERED to $990
Adjusted Yield To Maturity Is Now:
$1000 (return of principal from XYZ to the new owner of the bond) + $10 (capital appreciation between sell price of $950 and maturity value of $1000) + $50 (final interest payments) = $1060 (total return) OR 6% Yield To Maturity
The bond buyer is now willing to buy the XYZ bond from you as it is now equivalent to other bonds within the market place.
The same thing applies to when interest rates fall. The illustration below diagrams the effect of interest rates on bond prices.
IMPORTANT TO UNDERSTAND: While your portfolio of individual bonds may have declined in recent weeks due to the spike in interest rates it has very little to do with the outcome of your portfolio.
You come to me and say
"Lance, I have $1 million dollars and I need $50,000 a year in income to live on."
The table below shows $1 million dollars invested in a bond yielding 5%, which would generate $50,000/year, at different prevailing beginning interest rate environments. The table reflects the expected value at maturity of the bond and the income generated in varying interest rate environments. (Assumes all bonds are held until maturity.)
Regardless of the variation in interest rates there are two outcomes with bonds that a critical to understand. At maturity, the principal is returned in full, and the income from the bonds never changes.
If interest rates jump sharply, bond portfolios will go down in current value, however, regardless of where interest rates are at the time of maturity the full principal value is redeemed to the current owner. The only way to lose money in bonds (not withstanding bankruptcy or defaults) is to sell them in a panic because the media tells you it is time to jump into stocks.
Bond Funds & Bond ETF's
As stated above bond funds and bond related ETF's are nothing more than a bet on the direction of interest rates. These are NOT BONDS.
Bond funds and bond related ETF's do NOT mature at face value and return principal back to the owner.
Therefore, in 401k plans (where you generally cannot buy individual bonds), or for individuals trying to manage money on their own, you must manage your bond exposure relative to the direction of interest rates. This is the same fundamental premise as managing your equity related exposure in your portfolio relative to the direction and trend of the stock market.
The chart below is a long term view of a bond fund and bond ETF versus 10-year interest rates.
There is a much heavier negative correlation between exchange traded funds and interest rates. However, bond funds are also is impacted by the rise and fall of rates.
Currently, the spike in interest rates has made bond funds and bond related ETF's much more attractive for a short-term trading opportunity. Likewise, for individual bond buyers, the spike in yields has made bonds more attractive from a longer term perspective with slightly higher yields to maturity.
I continue to be bullish on the bond market through the end of this year, and most likely will into the future. With market volatility rising, economic weakness creeping in and plenty of catalysts to send stocks lower - bonds will continue to hedge long only portfolios against meaningful market declines while providing an income stream.
Will the 'bond bull' market eventually come to an end? Yes, it will, eventually.
However, the catalysts needed to create the type of economic growth required to drive interest rates substantially higher, as we saw previous to the 1980's, are simply not available currently. This will likely be the case for many years to come as the Fed, and the administration, comes to the inevitable conclusion that we are now in a 'liquidity trap' along with the bulk of developed countries.
While there is certainly not a tremendous amount of downside left for interest rates to fall in the current environment - there is also not a tremendous amount of room for them to rise until they begin to impact negatively consumption, housing, and investment. It is likely that we will remain trapped within the current trading range for quite a while longer as the economy continues to 'muddle' along.
Why You Should Own Bonds
There are many reasons why you should own bonds in your portfolio. However, here are my five primary reasons:
Reduces portfolio volatility Creates an income stream Preserves principal Reduces emotional mistakes Creates long-term returns in portfolios
As I wrote in "4 Keys To Successful Long Term Investing:"
"Risk does not equal reward. Too often, I get emails with statements of 'I am young, so I want to be aggressive.' This is a huge mistake. The reason is RISK is a function of how much money you will lose when you are wrong - and you will be wrong more often than you can imagine. The problem with being wrong is that the loss of principal creates a negative effect to compounding that can never be recovered. The table and chart below provides an example. (A portfolio of 100% stocks versus 60% stocks and 40% bonds)"
"The problem with following Wall Street's advice to be 'all in - all the time' is that eventually you are going to dealt a bad hand. By being aggressive, and chasing market returns on the way up, the higher the market goes, the greater the risk that is being built into the portfolio. Most investors routinely take on more 'risk' than they realize which exposes them to greater damage when markets go through a reversion process.
These corrections, as you can see in the example above, have two very negative effects on investors. The first is that the reduction of principal keeps the portfolio from meeting its original investment objectives due to the destruction of the 'compounding effect'. Secondly, the commodity of 'time' is forever lost. While investors will eventually be able to work themselves back to 'even' after suffering a brutal loss - the time component, and the subsequent lost return on invested dollars - is forever gone.
The next time a person trots out a chart of the return of the markets over the last 100 years - just remember that you will not live that long."
Lack Of Correlation Leads To Massive Corrections
Today the correlation between many asset classes has never been higher. With the increases in the flow of data cut down to milliseconds, the reaction of markets to news has become amplified. The days where diversification in stocks between international and domestic, capitalization and growth versus value no longer provide the lower risk profiles that could once be achieved.
In the market today it is no longer simply a choice of what stocks to buy. Rather it is the understanding of the inter-relationships between stocks, commodities, bonds, cash, and other investments and the risk profiles of each.
Lastly, it should be remembered that the market is currently engaged on the longest bull run in history without a 10% correction. The decline in momentum, the weakness in economic underpinnings and lack of Central Bank interventions(not to mention the threat of an increase in overnight lending rates)certainly provide the necessary ingredients for a sharper than expected correction this summer.
The risk is clearly elevated, and the potential reward of being aggressively invested currently leaves little to be desired. This is particularly the case given our discussion recently on the highest level of correlation between asset classes since the financial crisis.
"The degree to which securities move hand-in-hand is measured by correlation. A correlation closer to +1 implies more of a dollar-to-dollar move in prices.
According to a new study from the IMF, correlations, in general, are much more elevated these days than they were before the financial crisis. In other words, there are fewer places to hide in the markets when the markets start tanking. Check out the red bars in the chart."
This suggests that investors trying to "game the system" with sector rotation strategies will likely be swept up with the correction when it comes. While a"rising tide lifts all boats," the opposite is also true.
However, while Wall Street will chastise investors who fail to beat the benchmark index in any given year on the upside - it is avoiding the drawdowns that inure to the long-term performance of the portfolio. The mitigation of losses will significantly increase the probabilities of obtaining the original investment goals."
That is why you own bonds in a portfolio. YES - You will underperform the benchmark index in strong bull years. However:
1) Bonds return principal at maturity providing protection of investment capital - stocks don't.
2) Bonds create an income stream that enhances portfolios total returns, and;
3) Bonds lower portfolio volatility that reduces emotional investment mistakes and allows the portfolio to compound over the long term.
Now, go buy some bonds.
Have a great weekend.
Disclaimer: All content in this newsletter, and on Streettalklive.com, is solely the view and opinion of Lance Roberts. Mr. Roberts is a member of STA Wealth Management; however, STA Wealth Management does not directly subscribe to, endorse or utilize the analysis provided in this newsletter or on Streettalklive.com in developing investment objectives or portfolios for its clients. Please read the full disclaimer.