Does a Bond Bubble Mean Portfolio Trouble?
Many investors think that bonds are a necessary component to every portfolio. In the current market environment, Catamount has a more nuanced view.
How low can rates go and what it means for bonds in your portfolio:
Interest rates and bond prices move in opposite directions. As rates increase, bond prices decrease. Investors flock away from old bonds and towards newer bonds with higher coupons. Rates are currently near all-time lows and are expected to increase. This means that your upside is limited (if rates are low, the coupon payments from your bonds will be low) and that the downside is relatively high (as rates increase, existing bonds will decrease in value on the secondary market).* Even Alan Greenspan, the famous former chairman of the Fed, thinks that the bond market is currently in a bubble.
Dividend stocks as an alternative:
In the current market, we think stocks that pay out a dividend are a great alternative to bonds. They provide investors with income that can match that of bonds in some cases, but also allow for some of the upside of the equity markets. As a real-world example, let’s take a company in the Catamount portfolio that has highly-rated, investment grade bonds: Unilever (NYSE: UL). In the last year, one share of UL has paid out a dividend that is effectively 3.1% of the price of the stock a year ago. It has also seen an incredible stock price surge of 25%. If you had instead purchased a bond issued by Unilever, you would have lost 2.2% of the amount you invested. For some more nitty gritty detail, see the Appendix.
How we got to today:
After the 2008 market crash, prime interest rates were lowered to effectively zero. To put the period in historical perspective, below is a chart of the federal funds rate encompassing more than six decades. Recessions are highlighted in grey. To boost the economy out of a recession, the Fed will generally lower interest rates to stimulate the economy. As the economy heats up, the Fed will raise rates to cool things down and temper inflationary pressures on prices.
Federal Funds Rate 1954 to Present
What is amazing about the graph above is that the Federal Funds Rate was above 20% in the 80’s but is now only about 1%. As Big Lou likes to say, if we were in the 1980’s again, we would have a portfolio full of bonds.
What this means for bonds and your portfolio:
This means that return on bonds you can buy in your portfolio are historically very low. In the mid-1990s, highly-rated bonds (Moody’s Aaa rated bonds for instance), would yield 7.5% – 8.5%. This September, those same bonds have a yield of just 3.6%. With rates expected to rise, your returns on those bonds could be even worse.*
Should I sell my bonds?
The answer is not an automatic “yes”, or “no”. At Catamount we understand that each investor and each portfolio has specific needs. With highly-rated bonds do not generate as much income as they did in the 1990s. Investors looking for income from their bonds should consider this. If you look to riskier bonds that have higher returns, you run the risk of default. This can be seen with the recent bankruptcy bid by Puerto Rico that encompasses $70 billion of debt. On the other hand, if 3-4% income fits your portfolio’s needs, you should absolutely own bonds.
Every investment has a risk and reward tradeoff. In the current market environment, we think that investors should look at dividend yielding equities to as they consider income in their portfolio.
*Note: A standard bond will repay its principal in full (so long as it there is no default). This statement reflects the secondary market where bonds are traded and prices of a bond can move daily.