Sunday, October 5, 2014

Bonds Equal Risks


In all of the PIMCO/Bill Gross excitement and speculation about what money will stay and what will go where, no one is asking whether some or all of the money should exit the bond arena. By self-appointment I am asking the question both as a professional investment manager and a member of a number of significant investment committees. There seems to be a fundamental belief that once serious investment money is devoted to bonds one can change managers, durations and credits, but the allocation to bonds is almost sacrosanct. I believe as Socrates believed, "The unexamined life is not worth living." My proclivity is, almost child like, always asking why.

The classic reasons to own bonds

Bonds are a contract to pay interest and principal in a timely fashion. Thus no uncertainty about the future. Bonds provide income which can be spent or reinvested (particularly in open-end mutual funds). Historically bond prices move inversely to stock prices. Bond prices rarely go down.

The Siren pull of Bonds is Global

Ever since the bottom of the stock market, if not before, individual investors and many institutional investors have been adding to their bond holdings at a much faster rate than the appreciating equity holdings. I see this rush throughout the mutual fund world in almost every country that has a sizable bond fund market. While the rush is understandable for those who suffered equity losses by selling in the decline or seeing their wealth on paper shrink, nevertheless, I find any stampede a bit scary.

While I don't often agree with the SEC, I was heartened to read what SEC Commissioner Daniel Gallagher said in a speech to the Securities Traders Association in reference to the $10 trillion US corporate bond market. Commissioner Gallagher said "It clearly looks like a bubble." He indicated that roughly one quarter of the total is owned directly by retail investors and 73% of the $3.2 trillion of outstanding municipal debt is owned by "small investors." I don't know whether the Commissioner's numbers include bonds owned directly in open and closed end funds, defined contribution plans and variable annuities. My sense is that direct and indirect holdings of debt issues represent ownership of over half by individuals. He felt that in their chase for yield they did not stop to understand the risks of what they owned.

Commissioner Gallagher made another important point which was in 2008 the average daily trading was $1.04 trillion and in 2013 dropped to $ 809 billion. I believe trading has constricted even more in 2014 due to government regulations restricting the size of inventories that major banks and broker/dealers can own in their market making activities. Greater demand and smaller capital bases are likely to lead to an increase in bond price volatility.

On a temporary basis, Money Market funds appear to be a resting place. Weekly numbers on flows into Money Market funds seem to be growing at a rapid rate this week through Wednesday, according to Lipper, Inc. my old firm. I find this encouraging on two fronts.

First, the former owners of PIMCO funds may be reassessing where they should invest. (I would hope that they will reduce their bond investment.) Second, investors have not been scared off in using Money Market funds despite the SEC's misguided attempts to prevent a run on these funds. (They actually made a run much more likely, I fear.)

What are the risks in bonds?

The first risk is that high-quality bonds can go down in price. Over the last 15 years the Barclays Bond Market Index fund on a capital basis fell in six years or 40% of the time. Please note that this calculation is ignoring the income produced. Unfortunately, most bond investors utilize the income produced for their spending needs. They are ignoring the fact that with long maturities issues, the reinvestment of the interest in the then current interest rate market can produce more capital than the eventual return of their principal when it matures. A slightly less foreboding view can be had at looking at the last 40 quarters for the Vanguard Intermediate Term Investment Grade fund where it declined on a total reinvested basis 12 times or 30% of the time.

Second, the potential gains of investing in high quality paper is not going to be large enough to restore the starting capital of a balanced account with at least 50% in general equities.

Third, there isn't much if any room for interest rates to decline and therefore add to the value of existing bonds. At some point the manipulation by the major Central Banks can not ignore the misallocation of capital to higher credit risk issuers which will lead to lenders demanding higher rates. My guess is that this will happen sooner than the governments are expecting.

Fourth, the traditional concept behind a balanced fund is that when stocks periodically decline, bond prices will rise as governments will force interest rates down. In a major way this can not happen now. Bond prices and stock prices instead of being inversely correlated will move in the same direction, but at different momentums.

Fifth, the bond investor craves certainty. However, we are living in an uncertain world. I believe that we are going to be surprised by one or more changes listed:
·       Inflation
·       Tax Realizations
·       Contracts abrogated by courts and governments
·       Unforeseen crises which change cash flows

Sixth, a popular measure of risk is, how much can I lose? With bonds there is, perhaps, for an investment manager, a bigger risk. Bonds are essentially contracts and they are expected to perform in a specified manner. If they don't for any of the identified elements listed above, the expectational gap could endanger career risk for the manager.

The weakness of "My Word is My Bond"

I grew up in a world where stock exchanges were run by their member communities which enforced personal verbal contracts. You did not have to like the counter-party to a trade but you believed that the counter-party was good for his or her contract. The community would not tolerate any breaking of the contract. Under the current environment I hope and believe that my word is taken as acceptable. With what is happening today I don't know that I would have the same reliance on someone's else’s bond!

Note that this post is solely devoted to bonds. For our readers who are much more interested in stocks, I will, on request, be willing to share a portion of my September report on our private financial services fund which comments on three holdings of current interest.
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