Originally published: July 2019
This article provides a brief overview about investing in bonds and then dives into some potential trouble areas in the bond market.
I read thousands of emails from my readers, and one of the key themes I see is that people are concerned about the next stock market crash, and perhaps rightly so. By many measures we have high stock valuations in the United States after a decade-long bull market, and we have high corporate debt levels both inside the United States and globally.
But one question I rarely receive is: “Are bonds safe?”
From a historical perspective, the bond market is acting a lot weirder than the stock market at the current time. The stock market looks like it often does at this point in the business cycle, which is not great for the probable range of forward returns, but bonds are doing things they haven’t done ever before in history, which should give investors pause.
Since bonds are traditionally considered the safer asset class, should this be cause for concern? Are we in a bond bubble? Or is this just how things are now? This article examines the issue.
Read from the beginning or jump straight to the section you want:
- How Bonds Work: Bond Investing 101
- The Role of Bonds in a Portfolio
- The Role of Bonds for Traders
- A Potential Bond Bubble
- Is Inflation Solved?
How Bonds Work: Bond Investing 101
Unlike stocks that represent ownership stakes in a company, bonds represent debt. The bond buyer lends money to a government or corporation, and in return they receive a steady flow of interest payments back, and then eventually receive their principle back.
Stock valuation is hard because there are a lot of variables that can affect the outcome. There are a variety of growth rates that the company could achieve over the long-term, as well as a variety of different valuation multiples that the market might be willing to pay for it.
With bond investing, it’s more straightforward in principle. Either you get your money back or you don’t. And if you get your money back, do those dollars (or other units of currency) have good purchasing power, or have they been inflated/devalued/debased away?
That’s why as Benjamin Graham described:
Bond selection is primarily a negative art. It is a process of exclusion and rejection, rather than of search and acceptance.
Bond investing is by its nature more about avoiding bad bonds than buying good bonds. There is still, of course, tremendous skill in that industry because mistakes can wipe bond values out entirely, and predicting directions of interest rates is challenging. While bond investing may be more straightforward than stock investing, it’s just as difficult.
Bond Pricing
When an institution issues a bond, there is an interest rate or “yield” on it. A variety of factors based on supply and demand determine what that yield is. Bond issuers want the yields to be as low as possible while bond buyers want to get as much yield as they can for a given level of risk.
Longer-duration bonds generally have higher yields. Bonds from riskier institutions have higher yields. In contrast, short-term bonds and bonds from safe institutions generally have low yields, except for rare occasions where the yield curve is inverted.
But after they are issued, bonds also have a large secondary market, and their prices change based on changes in the prevailing interest rates, inflation rate, and credit risk. If interest rates go up, it means the bond price goes down. If interest rates go down, it means the bond price goes up.
The prices of those bonds on the secondary market are determined basically by discounted cash flow analysis:
- Bond Price refers to what investors are currently willing to pay for a bond.
- The Coupon refers to the payments made as part of the bond agreement to the bondholder for each year.
- i is the interest rate in decimal form. This is the yield to maturity that the bond buyer is targeting.
- Value at Maturity is the final payment the bondholder gets back at the end, or the “par value” of the bond.
Depending on the frequency of the coupon payments, there are several variants of this formula that can re-organize it into an easier form for the specific type of bond that is being priced.
The higher the interest rate “i” for the bonds, the lower the bond price will be, assuming the coupon and value at maturity are unchanged.
Bond Risks
With bonds, there are three primary risks to be aware of: default risk, interest rate risk, and inflation risk.
Default risk concerns the probability that the institution that borrowed money from bondholders will not be able to pay the money back in full. Many companies with too much debt default during recessions, for example. Credit ratings agencies such as S&P, Moody’s, and Fitch provide credit ratings on bonds to estimate how risky a bond is. The higher the risk, the higher the yield it must pay for bondholders to want to invest in it, all else being equal.
Interest rate risk primarily concerns the secondary market. You don’t have to worry about it if you hold individual bonds to maturity, but it’s a big concern for people who hold bond indices or bond ETFs, since these funds usually buy bonds at one maturity and sell them when they reach a certain point closer to maturity. If the default risk of a bond rises, or if inflation increases, or if central banks raise interest rates, bondholders might demand higher yields on existing bonds, which means the prices of those bonds decrease.
Inflation risk concerns the value of the currency that you’ll be paid back with even if the bond is not defaulted on, and affects bondholders that hold to maturity as well as holders of bond indices or bond ETFs. For example, if the inflation rate is very low, and interest rates are low, you might only get 2-3% interest on your bond per year, or less. But if inflation rises substantially, as it has occasionally in the past, the dollars or other currency units that you are paid back with might be devalued. If you lock in a 2% long-term bond, for example, and inflation averages 4% over the duration of that bond, then your inflation-adjusted return is negative.
Types of Bonds
Sovereign bonds from developed countries are considered the safest bonds. Sovereign governments with strong credit ratings that can print their own currency have very low risk of default, although investors must still pay attention to inflation (if held to maturity or held in bond indices/ETFs) and interest rate risk (if traded or held in bond indices/ETFs).
Local government bonds (municipal bonds, or “munis”) are issued by lower levels of government. They are traditionally considered fairly safe, although they do have some default risk because they cannot print their own currency. Many places have tax-exempt status for them.
Investment-grade corporate bonds are issued by large businesses. Many of them are very safe (like Microsoft), while others can have moderate risk (like General Electric). As a whole, they have more default risk than governments because they cannot print their own currency.
High-yield bonds, also called “junk” bonds, are non-investment-grade bonds issued by companies or other institutions. They have too much debt, or inconsistent cash flows, and so investors demand higher yields from them.
Convertible bonds pay interest but can also be converted into shares of stock under some situations. Some companies don’t have good credit ratings but can’t tolerate higher yields, so they issue a moderate-yield bond with the added upside of allowing the bond to convert into stock if the company does well.
Emerging market bonds are issued by sovereign nations or companies in emerging markets. Emerging markets often experience higher inflation and higher default risk, so the overall risk and yields tend to be high for this category. They are similar to the high-yield bond market but with a different and rather uncorrelated risk profile.
The Role of Bonds in a Portfolio
Investing in bonds traditionally adds an element of stability to a long-term portfolio and helps to diversify it.
Safe bonds often increase in price during recessions because central banks cut interest rates and investor demand for bonds increases, and both of those factors can drive yields down and bond prices up.
A diversified stock/bond portfolio that is re-balanced annually has historically been less volatile than a pure stock portfolio, with returns that are almost as good. Here, for example, is the 10-year recovery chart for U.S. stocks from the 2008 global financial crisis:
Chart Source: JP Morgan Guide to the Markets
Blended stock/bond portfolios had smaller drawdowns and faster recoveries to full value than all-stock portfolios during the aftermath of the global financial crisis.
Riskier bonds, like junk bonds, often behave a lot like stocks and sell off during recessions. More of them start defaulting, so investors demand higher yields and bond prices fall. So, unlike safer bonds, they are not as good for the purpose of diversification, and are often left to traders rather than long-term investors.
The Role of Bonds for Traders
Bonds have a reputation for lower returns than stocks, but that’s not always the case. Some bond traders try to earn bigger profits on their bonds by buying and selling them at the right time. This is a considerably different practice than buy-and-holding a 60/40 stock/bond portfolio.
For example, if a bond trader buys a high-yield junk bond from a troubled company, and that company improves its performance and achieves investment-grade status, its interest yield will decline and its bond price will increase. In addition to collecting interest for a period of time, the bond trader would sell it for a big capital gain.
Similarly, if inflation is high and sovereign bond yields are high, a trader might have a conviction that inflation will decrease and bond yields will decrease. So, she might buy bonds at higher yields and sell them for lower yields (and higher prices) when inflation and yields decline in the future.
For this reason, even low-interest long-term safe bonds can potentially provide large capital gains if investors correctly judge the future direction of their yields. Of course, if they judge poorly, they are vulnerable to a capital loss from higher yields and lower bond prices.
Daniel Amerman charted, for example, that the 1-year capital gains from buying a 10-year treasury at a starting yield of 2.5% and selling it a year later at a yield of, say, 0.50%, would be almost 20%:
Source: Daniel Amerman CFA
On the other hand, if the yield increases to 5.5%, it would be nearly a 20% capital loss within a year. Longer-duration bonds of 20 or 30 years or more would magnify these effects.
A Potential Bond Bubble
Global bond markets are doing spooky things lately that investors should be aware of. There is now over $13 trillion worth of negative-yielding bonds in the world:
Chart Source: Bloomberg
Most of these negative-yielding bonds are from the Japanese government and several European governments. Interest rates have gotten so low that many of them have turned negative, meaning that bondholders are paying for the privilege of lending to these governments rather than getting paid for it.
The inflation rate is low but positive in these countries, so the inflation-adjusted returns for bondholders that hold to maturity are even more negative, unless deflation occurs in the future.
There have also been some really interesting bonds issued.
In 2017, Austria issued a 100-year bond, payable in 2117, with an interest rate of only 2.1%. It is now trading with a 1.2% interest rate, while their inflation rate is 1.6%. At current rates, this bond offers a negative real return for a century.
How many currencies even last a century? The map of Europe didn’t look anything a century ago like it looks today. What will it look like in 2117? Will Austria exist? Will the Euro currency exist? Furthermore, if there is any significant inflation over this period, the value of the bond could be wiped out even if paid back in 2117. Is there any realistic scenario where this would be a good investment if held by an institution for a long time?
Italy recently issued a 50-year bond with an interest rate of under 3%. Italy has one of the highest debt-to-GDP ratios in the world and does not print its own currency (the Euro), so their default risk is not super low. Remember, as recently as 2012, Italy’s 10-year bonds reached 7% yields during the European Sovereign Debt Crisis when investors were worried about the ability of Italy, Greece, and other southern European nations to repay their debt.
Chart Source: Trading Economics
Italy’s debt-to-GDP is now higher than it was in 2012, but investor demand for its bonds is so great that its bond yields are lower than U.S. treasury yields, and it can issue 50-year bonds with huge demand for sub-3% yields. Weird.
Some “high-yield” bonds in Europe now have negative yields too, ironically. In other words, some non-investment-grade companies with a credit rating of BB (generally called “high yield” or “speculative grade” or “junk”) have issued bonds that have negative interest rates. It doesn’t take a rocket scientist to realize that this is not a healthy risk/reward profile for an investment.
Many bond traders have made money by buying these bonds and then selling them as yields have dipped. They are betting on the idea that the European Central Bank will do more quantitative easing, which is a practice where the central bank buys bonds and drives their yields lower. But is this sustainable, especially for long-term investors that actually hold these bonds for years and decades?
Many pension funds, insurance companies, and other institutions are mandated to hold investment-graded bonds for a large portion of their portfolio. If all investment-grade bonds offer low or negative yields around the world, many of these institutions get more desperate and buy super-long term bonds with slightly higher yields. But that can cause a serious problem if we ever see higher interest rates or inflation within the next decade or two.
Would you buy a safe company with no growth for a P/E ratio of 50? That’s what it’s like to buy an ultra-long-term sovereign bond with a 2% interest rate.
Is Inflation Solved?
These super-low bond yields are based on the premise that inflation is low and will remain low forever. If inflation goes substantially higher, the value of these bonds could be decimated.
Inflation through much of the developed world has decreased substantially over the past four decades. This chart, for example, shows the official inflation rate in the United States (red line) and the 10-year treasury yield (blue line) since 1965:
Chart Source: St. Louis Fed
Investors have enjoyed a four-decade multi-business-cycle bull market in treasury bonds. Since bond prices go up while interest rates go down, and they have been in a four-decade decline, bond returns have been great. But now U.S. government bonds are getting close to rock bottom like the rest of the developed world.
The real yield of 10-year treasury bonds, meaning the nominal yield minus the inflation rate, is now bouncing around close to zero:
Chart Source: St. Louis Fed
Real treasury returns were bad for a while leading up to the late-70’s inflation spike, but during the 1980’s, 1990’s, and much of the 2000’s, they have provided positive real returns. In the past decade, however, their real returns have bounced around zero, treading water with the low inflation rate.
In 1979, BusinessWeek issued the infamous “Death of Equities” magazine cover, with the tagline, “How inflation is destroying the stock market”:
This piece was infamous because it was the beginning of the biggest bull market ever in U.S. history. It was a contrarian signal at the point of ultimate pessimism; stocks did tremendously well for the next two decades.
This year, BusinessWeek issued another cover, this time called, “Is Inflation Dead?” Hopefully this doesn’t end up being another contrarian signal, where we look back on this as being ironic.
Similarly, a big opinion piece on Business Insider’s homepage recently proclaimed that Inflation is Solved.
Some of the notable quotes from that article:
- “That’s because we have solved inflation. It is no longer a problem. Macro deflationary forces are more powerful than central bank monetary forces.”
- “That, really, is the headline here: inflation no longer exists.”
- “Inflation has been solved. We solved it, through our new inventions.”
Inflation has been on the decline in the developed world for many reasons:
Aging demographics puts downward pressure on consumer spending. Consumer spending peaks in a family’s early/mid adult years. As a larger portion of our population consists of the elderly, consumer spending is diminished, which puts downward pressure on prices.
Globalization means simple goods can be made by cheap labor abroad rather than by higher-paid workers domestically. Imagine how expensive your furniture would cost if it was all made by hand by carpenters in your community rather than China. What if all your clothes were made in New York rather than Bangladesh? How expensive would your computer be if the circuits were assembled by high-paid technicians in Europe, rather than in Vietnam? These global supply chains have reduced prices for many goods.
High global debt is deflationary. It makes it harder for economies to grow, and when debt defaults, it destroys someone else’s assets.
Better technology makes things cheaper, or even free, and we’ve had an unusual boom in technology over the past few decades. Factory automation makes physical products cheaper. Smartphones combine multiple pieces of technology into one portable device. Fracking has increased the oil supply and made it cheaper. And as Business Insider’s article stated:
Spotify makes music cheaper. Uber makes taxis cheaper. Google makes information cheaper. Facebook makes advertising cheaper. Amazon makes shopping cheaper. The gig economy makes wages cheaper.
Normally, when central banks keep interest rates low, it makes a currency vulnerable to inflation because it encourages borrowing and discourages saving. For this reason, central banks generally raise interest rates when unemployment gets low and inflation starts to rise, which tightens the money supply and quells inflation.
However, with all of these deflationary forces, central banks in developed countries around the world have been able to keep interest rates at-or-near zero for over a decade now, and have been able to use unusual techniques such as quantitative easing (print money to buy bonds, roughly speaking) without causing high inflation.
But is inflation as low as it seems? In this world awash with liquidity from quantitative easing, the prices of many things have indeed increased faster than the official consumer price index (CPI).
There are many key things that all of this new technology, globalization, and changing demographics have not made cheaper. Healthcare costs, college tuition, professional services (accounting, engineering, etc), and housing prices have all increased much faster than inflation in the United States. The costs of these things don’t benefit much from the gig economy, workers in Bangladesh, aging demographics, or even technology:
Chart Source: Incrementum
So if bonds are paying ultra-low or even negative yields, while healthcare and tuition costs (some of the biggest costs for the middle class) are pushing up at 5%+ per year, is that okay? Do cheaper electronics, toys, and cars offset that? Housing prices are also going up a lot, but at least are being offset by lower mortgage rates. The point is, this lack of inflation is not evenly spread. The costs of some critical things, like healthcare, are going up dramatically while other things are outright deflating in price.
What will happen if some of these trends slow down?
Could increased nationalism put a halt to globalization? It’s certainly possible, because global trade as a percentage of global GDP has already topped out for a decade now. I think we might have reached the peak.
Could the rate of technology deflation slow down? We’ve had a revolutionary decade for the proliferation of smart phones and all of the app services that come with them. And we’ve reached a peak level of unprofitable IPOs and tech companies. What if investors start asking their companies to actually earn a profit? Have we already achieved most of the cost-reduction benefits from these technological trends, and could this process revert to a more normal trend line going forward?
The Power of Central Banks
Central banks around the world are nowhere near out of ammo for causing higher inflation if they want to, and many of them do have higher inflation targets than what they are currently experiencing. The U.S. Federal Reserve, Bank of Japan, and European Central Bank have all publicly expressed their disappointment in reaching inflation targets, meaning that inflation is running lower than they would prefer.
Low interest rates and quantitative easing may be near their limits of effectiveness, but central banks have other tools if they choose to use them. Central banks absolutely do not want deflation, and will not allow it. Deflation makes debts unpayable and brings an economy to a halt.
Saying that macro deflationary forces are more powerful than central bank monetary forces is like mistakenly saying Superman isn’t very strong when really he’s just holding back.
Superman holds back most of the time because he doesn’t want to accidentally kill his friends or knock down skyscrapers. He’s a nice guy. If for some reason he decides not to hold back, he can overpower basically anything, sometimes to disastrous results. There are occasional story arcs in the comics where Superman has to go all-out on a world-threatening arch-villain, like Doomsday or Darkseid.
Central banks and treasuries around the world create and control currency. They can do unusual things with it if they want to. There are all sorts of historical precedents for devaluing currency, inflating debts away, or creating fiat money out of thin air as needed.
They just have to be careful because if they push it too far, people can lose faith in a currency and it becomes worthless. If currency creators take the gloves off and want to cause inflation, they will cause inflation. The only problem would be making sure they don’t cause hyperinflation. Superman can kill an enemy if he has to, but the question is, can he do it without bringing the city down around him?
In 1933, the United States devalued the dollar by about 40% by redefining the dollar from being worth about 1/20th of an ounce of gold to only 1/35th of an ounce of gold. The government later devalued the dollar again in 1971 by taking it off the gold standard. They just changed the definition of what money is. Macro-deflationary forces are nothing against you when you have the ability to change the definition.
Currency devaluation has been standard practice for countries throughout history as their debt levels reached unsustainable levels. Currencies today are not linked to any commodities, and so currency devaluation would take the form of money-printing. Those that create currency can decide how much of it exists. They could hand it out like candy on Halloween if they want to, but they don’t do so because it would make each unit worth much less (aka inflation).
Lately, Modern Monetary Theory is the hot topic in financial media. It’s an approach that blends central bank policy with fiscal policy to print as much money as needed up to the point where inflation becomes a problem, and is what some politicians and economists advocate should be done in many developed countries.
So far, central bank tools have not been inflationary because they have primarily benefited asset prices rather than middle class consumption. They printed money, but kept the money on the central bank balance sheets by buying bonds.
If central bank actions get more aggressive, combine with fiscal policies, and start targeting the middle class, they have the power to override these various deflationary forces with sheer monetary expansion. They can issue helicopter money to pay off debts, boost inflation, build infrastructure, bail out unfunded pension systems, and prop up the middle class if that’s what policymakers decide to do.
I wouldn’t want to be holding a 20-year or 30-year bond at super-low fixed yields in that kind of environment. Negative yields would be even more vulnerable. Sometimes Superman goes all out, and every few decades, central banks do unusual things.
Final Thoughts
This chart shows the ratio of U.S. household net worth to disposable income over the past several decades:
Chart Source: St. Louis Fed
In the 1960’s, the ratio was about 550%, but declined to about 450% as inflation picked up and high interest rates pushed down the valuations of stocks, bonds, real estate, commodities, and basically everything.
Since then, the ratio has been on the rise. It hit a peak in 2000 due to overpriced tech stocks before coming down. It hit a higher peak in 2007 due to the overvalued housing market before coming down again. It has reached a new peak over the past year, as the valuation of stocks, houses, bonds, and other assets are all at very high levels thanks to ultra low interest rate policy.
I am very cautious about long-term bonds today. The case for a bond bubble is significant. Yields have never been this low in the modern era, and the unanimous consensus seems to be that inflation is dead and we never have to worry about it again.
I think it’s certainly possible that we’ll see higher yields and higher inflation again in the coming decades, which would be very bad for bonds at such low current yields. There are many deflationary forces in the world, but governments have too much debt to allow deflation, and their central bank policies can cause inflation if they need to. The last time we had a situation like this, in the aftermath of the Great Depression, inflation did follow.
Chart Source: Ray Dalio
However, certain bond yields could very well go lower (and thus bond prices higher) before the trend reverses. Many investors, for example, believe that the U.S. 10-year treasury will follow in the footsteps of Japan and much of Europe during the next recession and go to 0%. In that case, holding long-term treasury bonds for the next year or two or three (and then selling them) would be lucrative.
I would tread carefully and be cautious about taking certain trends for granted, like low inflation.
I don’t know how long yields will stay this low and how low they will ultimately go before things reverse in one way or another. However, the risk-reward for most long-term sovereign bonds, other than perhaps 10-year treasuries, is not attractive. The upside potential for holding negative-yielding debt is not great over the long term, but the downside risk in the event that central banks become more aggressive is high.
Cash, precious metals, blue-chip dividend stocks, and real estate outside of high-priced major cities, all generally offer better risk/return potential at the current time in my view than long-term low/zero/negative-yielding bonds.
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