Are Bonds Really Safer Than Stocks?
It is commonly perceived that bonds are a “safer” asset class than stocks. We come across this perception in conversation with clients, potential clients, and sometimes even with peers in the wealth management industry. How many times have we heard the words “safe” and “bond” in the same sentence? But bonds are not always safe. In this post, we will illustrate risks inherent in bond investing and market dynamics to beware of.
Bonds have four primary attributes to consider:
- Principal/Par Value – This is the amount of money that will be paid out once the bond matures. A newly issued bond usually sells at the par value.
- Coupon – This is the amount of money the bondholder receives as interest payments.
- Price – This is the bond’s current price in the market.
- Yield – Yield is a figure that shows the return you get on a bond. The simplest version of yield is calculated using the following formula: yield = coupon amount/price. When you buy a bond at par, yield is equal to the interest rate. When the price changes, so does the yield.
Let’s demonstrate this with an example. If you buy a bond with a 10% coupon at its $1,000 par value, the yield is 10% ($100/$1,000). Pretty simple stuff. But if the price goes down to $800, then the yield goes up to 12.5%. This happens because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).i
The prospect or expectation of rising interest rates, which we face during 2017, is one market dynamic that makes bonds a less attractive and even risky investment. Bond prices and interest rates have an inverse relationship – when interest rates rise, bond prices fall. This inverse relationship may seem counterintuitive, but after consideration it makes sense. When interest rates rise and new bonds are issued, the new bonds will have a higher coupon rate than the previously issued bonds – this creates a dynamic where the yield on older bonds is no longer competitive or attractive because it is lower than the yield on new bonds; in order compete with the newly issued bonds, prices fall across older bonds until their yield is on par with the newer bonds. That is a lot of information to digest, so consider the following simple example.
Imagine if we were to buy a bond today with a 10% coupon for $1,000 – this bond would pay $100 and the yield would be 10% ($100/$1,000). And then in a year, interest rates doubled and newly issued bonds had a 20% coupon with the same $1,000 principal. These new bonds would make our old bond less attractive because they pay twice as much! To remain competitive in the market, the price of our older bond would have to drop to $500 for its yield to reach 20% ($100/$500). Ultimately, our recently purchased $1,000 principal bond would be worth $500 – a 50% loss on our investment.
Inflation can both directly and indirectly effect bond prices. During periods of high inflation, the Federal Reserve will often raise interest rates to tighten the money supply and curb inflation. As we now know, interest rates and bond prices have an inverse relationship and a rise in interest rates pushes bond prices down; in this case, inflation is indirectly having a negative effect on bond prices. More directly, inflation reduces the purchasing power of a bond’s coupon payments and its overall yield. For example, consider the performance of a short-term bond that yields 1% over the course of a year with 4% inflation, this bond will yield a 1% nominal return but when you adjust for inflation, the bond will yield a -3% real return.
Finally, it is important to consider default risk and trading liquidity. Although these are typically not large risks in treasury or municipal bond investing, they exist across corporate and high yield bond investing. When a corporate bond is purchased, the purchaser is ultimately reliant on the respective corporation’s ability to pay the interest payments and, eventually, the principal; sometimes, due to unforeseen economic circumstances or poor performance, payback isn’t possible and the loans are defaulted. It is also important to consider trading liquidity, as corporate bonds often trade at low daily volumes. Low trading volumes make it hard to get out of positions, and this dynamic can push prices down.
If you have any questions about this post or bonds in general, please reach out! Thanks for reading and please share this post.
Today, we are highlighting Amazon (NASDAQ:AMZN) and Tesla (NASDAQ:TSLA). For years an out performer, we see Amazon as significantly undervalued. Here is why we are bullish:
- Amazon’s P/S ratio (price per sales) is relatively low given Amazon’s revenue growth. And beyond recent revenue growth, Amazon’s valuation multiples don’t fairly encompass future growth prospects across its e-commerce and web services businesses (Amazon AWS). Amazon experienced 22% year over year sales growth in the first quarter of 2017, which we feel renders its 3.2x revenue multiple as cheap.
- Amazon Web Services, the company’s cloud computing division, represents an undervalued asset within Amazon. In the first 2017, AWS represented ~10% of aggregate revenue for Amazon, but contributed ~88% of operating profits. AWS did $3.7B in sales in the first quarter of 2017, up 43% from the prior year, and reaching an annual run rate of around $15 billion. For comparison, Equinix (NASDAQ: EQIX) is the largest pure play publicly traded cloud computing company, and its first quarter 2017 revenue was only $949MM, with a much lower 12% year over year growth rate. In a market where other comparable cloud computing companies like EQIX trade at 8-10x revenue, AWS would be worth around $130B as a stand-alone entity. Amazon continues to grow this business and has recently added ~300 new services and features to AWS. This should continue to drive adoption and revenue growth to a business that already has lots of momentum.
- Amazon’s international segment currently operates with negative margins. However, Amazon has strategically operated many of its businesses at a loss to offer better prices than competitors, win new customers, and ultimately drive penetration and take market share. This has been effective and Amazon has grown revenues in this division by 16% year over year. We expect Amazon to replicate its North American success elsewhere and operate profitable businesses when it strategically makes sense. Its international business represented ~30% of aggregate revenue in 2016 and we expect this number to grow, coupled with increasing margins over the long term.
Despite recently trading at all-time highs, we see significant upside and growth potential for Tesla. Here is why we are bullish:
- Tesla has had impressive growth recently; it delivered 25,000 vehicles globally during the first quarter, a 69% year over year increase from the first quarter of 2016. And, with a 2018 target of delivering 500,000 cars, Tesla is on track for sales of $25B. It is important to note that Tesla’s already impressive 26% gross margin per car will increase as it delivers more cars, and analysts have speculated that this margin could reach 30%. For reference, most car companies, like GM and Ford, have gross margins per car that hover around 10%.
- Despite impressive manufacturing build out, the company has kept a relatively low debt level. International market leaders Daimler (DIA) and General Motors (GM) both have total debt to total capital ratios of ~66%. Tesla’s comparable ratio is 57%. This indicates that Tesla is below market leaders in its use of debt to finance its operations and that the company room the use debt to finance future manufacturing build outs.
- We see Tesla as more than a traditional car company, we see it as an innovative tech and design company; like Apple, Tesla produces industry leading cache’ products with justifiable premium pricing and a differentiated delivery model. We see Tesla as a diversified business that will continue to capture the shift in consumer preferences toward electric cars, while being a leader in the nascent self-driving car space, and building a significant battery business.
2016 was a volatile year across the global geo-political landscape and the inherently connected financial markets. Seemingly unlikely events, Brexit and the election of Trump, shook the world. 2017 too will be filled with unknowns and volatility. Here are a few tips for protecting your wealth and navigating the market’s ups and downs.
Diversify Your Investments
Diversification has always been the key to distributing and managing risks inherent in investing. What does it mean to be diversified? Let’s start with an example: Imagine a portfolio that was entirely comprised of holdings in just two stocks, Facebook (FB:NASDAQ) and Twitter (TWTR:NYSE). This is called a “concentrated” portfolio; if Facebook has a bad quarter in terms of earnings, or one of its core products like Instagram loses market share to a competitor like Snapchat, or any number of things goes wrong, our concentrated portfolio will be very sensitive to any downward move in the stock price. Beyond just owning two stocks, both Twitter and Facebook are technology sector stocks; if President Trump were to announce policy unfavorable to this sector, the portfolio would be incredibly sensitive. Alternatively, a diversified portfolio has a balanced mix of holdings across assets classes – stocks across different sectors (International, Emerging markets, Tech, Consumer, Telecom, Industrial, Energy), bonds, precious metals, real-estate, and cash. The more diverse the holdings, the less reliant a portfolio is on the success or failure of any one asset class, sector, or stock. At Catamount, we construct appropriately diversified portfolios based on the risk appetite and goals of our clients.
Over the long run, the stock market has a long-term tendency to rise – this simple fact is something to remember through the market’s day-to-day and even year-to-year volatility. The key to growing a portfolio is to stay put and patiently ride through the market’s turbulent peaks and valleys. If you can do this, you will take advantage of market’s long-term rising trend. However, studies show that most people often do the exact opposite and instead of staying put they can’t resist the natural urge sell their positions during market corrections, set-backs, and crashes. These people are in effect buying high and selling low, or buying low and selling low, when the ultimate goal is to buy low and sell high. In fact, a market correction often presents a great opportunity to be investing in the stock market instead of selling. This idea is summarized well in this tweet from macro-investor Cullen Roche:
Do you have a 360 degree all-encompassing view of your assets? Are they are working cohesively under the same risk parameters and growth thesis? We often come across potential clients and clients who are working with several different wealth advisors, tax-advisors, or estate-planners. This can lead to a redundancy in positions, unnecessary fees, and a confluence of different philosophies, yielding a less effective approach to growing and protecting wealth. One of the first things we advocate across our clients is a consolidated and simplified approach. At a minimum, it is important to make sure that there is communication between different moving parts so that you have a well-defined and universal approach to market volatility and market corrections.
With a mix of new features, businesses, and opportunities, we expect Facebook to have a great year in 2017. Here is why we are bullish:
- Cheap Valuation based revenue growth (56% in 3rd quarter year over year[i]) (will add specifics and elaborate on P/E when we are going to actually post this so that the #s current)
- Facebook has the potential to be a dynamic and large player across the e-commerce landscape. Over the past year, FB has made had strong entrance into several e-commerce markets via partnerships with companies like Uber, Domino’s, Kayak.com, and more.[ii] These partnerships enable Facebook users to communicate and transact with these brands within Facebook Messenger. Additionally, FB has created its own version of Craigslist, a marketplace native to Facebook where users can buy or sell items with each-other. FB will take market share across the e-commerce landscape over the coming years and ultimately increase its revenues.
- Instagram’s “Stories” feature is both an attack on Snapchat’s market share in the teen demographic and a significant addition to Facebook’s advertising inventory. In 2016, Instagram effectively copied the Snapchat stories feature and did well incorporating it into the Instagram interface. Stories enables users to broadcast photos & video clips to their followers; these photos & videos expire 24 hours after they have been posted. Stories also enables users to live stream video content. Instagram has been incredibly successful in driving users to this new feature, and, having demonstrated strong engagement, Instagram is partnering with large brands such as Nike (NYSE:NKE) to distribute branded video content and ads.
Coming off a strong 4th Quarter in 2016, where EPS (earnings per share) registered $0.40, Bank of America should to continue to do well in 2017. In particular, BAC stands to benefit from President Trump’s promise of deregulation and the FED’s intent to raise interest rates.
- The Dodd-Frank Act and post financial crisis stress tests, both intended to safeguard the broader economy, have limited Bank of America and its banking peers in their ability to generate returns on capital. These regulations prohibit the banks form being illiquid, which effectively means that they need to keep lots of cash on hand and limits the assets that can be tied up in illiquid things like loans. Currently, BAC has ~$500 billion of cash on hand. If Trump is able to relax or even dismantle Dodd-Frank, BAC will be able to allocate a portion of that cash to its loan portfolio which yields ~4% annually – this redistribution of cash would boost BAC earnings significantly.[iii]
- Almost half of BAC revenues are tied to interest rates and a 100 basis point (1%) upward move in interest rates would yield an additional ~$5 billion in revenues. Of the big banks, BAC most benefits from rate hikes because it has the largest portion of its earnings tied to interest rates. If rates rise and are coupled with a cash redistribution into its loan portfolio, BAC would dramatically increase its annual earnings.
“The information contained within this blog is provided for informational purposes only and is not intended to substitute for obtaining professional financial advice. Please thoroughly research everything you read here and seek professional representation before acting on any information you may have found in this blog.”