Wednesday 21 August 2019 by Guest Contributor Opinion

Interest rates are low, how does it affect bonds?

This article was written by Jared Dillian from The 10th Man.

Interest rates are currently low. That was by far the biggest concern mentioned in the bond survey. People are drowning in worry about low interest rates and their effect on bonds. So let’s address that. 

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Saying interest rates are currently low is another way of saying that bonds are expensive—which makes people not want to invest in bonds. Fair enough.

Stocks are also expensive—but you invest in those!

So why are you willing to invest in expensive stocks, but not in expensive bonds?

What are your alternatives?

  • Cash
  • Commodities
  • Real Estate
  • Collectibles

None of those look appealing right now.

Here’s the reality of the situation. If you have capital to spare, you—as an individual investor—are going to end up putting most of it in the stock market and the bond market, because those are the deepest, most liquid capital markets.

I suppose you could go on strike, and keep it all in cash. One day that might make sense.

I suppose you could go on strike, and keep it all in commodities, but they are not cheap to carry.

Or real estate, but that has special risks.

Stocks and bonds—those are your choices.

So I ask you again: why are you willing to invest in expensive stocks, but not expensive bonds?

Yes, it would be nice if stocks and bonds were cheaper. But that is not the world we currently live in.

Diversification

The reality is that you need both stocks and bonds to have a diversified portfolio. No matter how expensive they get.

Stocks and (most) bonds behave differently. Sometimes stocks go up and bonds go down, and vice versa. This smooths out the volatility in your portfolio.

The stock market gets volatile sometimes. I wouldn’t want my entire nest egg in an asset class that is ripping around 7% a day. The bond market is occasionally volatile, but nowhere near as volatile as stocks.

And having bonds in your portfolio does more than reduce the volatility—it also improves the risk characteristics of your portfolio. It makes your portfolio more efficient in its use of risk.

You can compare one portfolio against another portfolio to determine which one is better. And a portfolio that is mostly bonds has the most efficient use of risk, which makes it better. What I mean by that is you will have a better rate of return per unit of risk

It has zero to do with the actual level of interest rates. Interest rates could be negative, and you would still want bonds in your portfolio, for risk reasons.

This is called diversification. Diversification is the idea that adding something “bad” to your portfolio can actually make it good. Anyone who has done any academic work on portfolio management (including CFAs) know this is true.

Once more for those in the back, low interest rates do not mean you should not own bonds.

Some people get all huffy about low/negative interest rates. Negative interest rates are socialism! Negative interest rates are manipulation!

Maybe not.

The classical definition of interest rates is the price of money that balances the supply and demand for loanable funds. 

There is a huge supply of loanable funds out there. There is a giant wall of money that needs to find a home. There is so much money that we can’t even find places for it.

Is that a consequence of central banking? Maybe.

Do you want to fight it? Probably not.

But What About Inflation?

If you own bonds that yield 2% and inflation is 3%, you will have a real return of -1%. This is an indisputable fact. Inflation hurts bonds.

Core PCE (the personal consumption expenditures price index) recently came in at 1.6%. It seems like we should be having more inflation, but we aren’t. I personally think inflation will go up! But it isn’t going up much now.

Even if it does, what are your options? Stocks are supposed to keep up with inflation, but what if they don’t?

Actually, your options in a high-inflation environment are commodities and real estate, and there might come a point in time where inflation ramps and you want to be in commodities and real estate (like the late 1970s), but that is a very long way off.

So we are back to stocks and bonds, both of which are overvalued, and both of which you have to own. There is a chance that returns on both stocks and bonds will be low. But if you want to be invested, you have to own both of them!

Finally—and a lot of people are missing this—there is the very real possibility that bonds outperform stocks over the next few years.

Last week I talked about convexity and the possibility that bonds will go parabolic.

If you know anything from reading The 10th Man over the years, you know that not only do stupid things sometimes get more stupid, stupid things usually get more stupid.

Negative rates may be a bubble, but bubbles can last for years.

Stan Druckenmiller (if my memory serves me correctly) was forced to retire and convert to a family office when he lost a fight with the bond market. And that was when yields were a lot higher!

I’m not pushing anything radical here. All I am saying is this: if you are an ordinary investor, and not a macro hedge fund manager, you should have a mix of both stocks and bonds, and probably more bonds than you think. That’s it.

We need less of this…

“My sister’s financial advisor thinks she should be 100% invested in tech stocks like Facebook, Amazon, etc. and [that] she can withdraw 7% every year and grow her account. My sister is 77 and has no source of income beyond Social Security and is in assisted living. Where did ‘know your customer’ go?”

…And more of this…

“[Bonds’] low income is a bitter pill to swallow when the stock market is soaring, but I can sleep at night (as opposed to 2008 - 2009, when I lost half my savings).”

(Both of these comments are from The 10th Man readers.)

This article has been re-produced from The 10th Man, https://www.mauldineconomics.com/the-10th-man/interest-rates-are-low, written by Jared Dillian.
www.mauldineconomics.com/important-disclosures

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