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Bonds – The Next Lost Decade

Market Summary – 3rd Quarter, 2010


Gordon Gekko, the iconic character of the original 1980s movie “Wall Street,” is best noted for his phrase “Greed…is good.” Gekko took greed to an extreme, and many investors did the same in the years that followed. Now, we’re seeing investors follow a different extreme – fear.

Columnist Chuck Jaffe, writing on the Marketwatch website, updates Gekko’s trademark slogan. Jaffe says today’s investors are best served if they understand that “Greed is good, and so is fear. Investors who keep both in moderation – and have a strategy that doesn’t give in to either of those two extremes – will find out that while their money never sleeps, it doesn’t have to beat everyone else to win the game.”

Investors apparently can’t help themselves from overreacting. Just as they got too greedy during the “dot-com” era of the 1990s and again in the mid-2000s with financial stocks, today, investors are too fearful. As a result, money continues pouring into bond mutual funds just as interest rates reach close to their historical lows.

q310 cartoonWhat is lacking is a sense of balance. Many fail to recognize the impossibility of accumulating wealth by lending money to the U.S. government for 10 years, with a payback of only 2.5% per year, the approximate current yield on 10-year Treasury notes. Keep in mind the annual inflation rate has averaged 2.8% over the past two decades.

The real irony for those seeking a safe haven in bonds is that they may be setting themselves up for the next “lost decade.” Since the stock market hit bottom in March 2009, investors have poured money into bond funds and steered away from domestic equity funds. In that same period (March 31, 2009 through Sept. 30, 2010), they settled for modest returns from bonds and missed out on a strong rally in the stock market.

Bond investors just experienced one of the most favorable decades in recent times. Things change and now there are a number of reasons why bond investors need to be wary. The hurdles they face include:

Unattractive valuations
We all remember the “dot-com” bubble of the late 1990s. Stocks of certain technology companies reached excessive levels. While some felt the urge to get in on this “hot” market while they still could, it became obvious that stocks were overly valued based on their earnings. Today’s bond market feels a lot like that. Professor Jeremy Siegel of the Wharton Business School in The Wall Street Journal (“The Great American Bond Bubble,” August 18, 2010) uses the example of Treasury Inflation Protected Securities (TIPS), with a recent yield of 1%. At that level, a $1,000 investment earns $10 of interest in a year. In essence, the bond costs 100 times the annual payout. That is an expensive price for any investment, particularly for a fixed income vehicle that is not positioned to generate capital appreciation.

Refinancing boom
The U.S. government has $8.3 trillion in outstanding debt. More than 60% of it ($5.2 trillion), comes due within the next three years (according to Jason Desena Trennert, writing in The Wall Street Journal, September 10, 2010). This matters to bond investors because the U.S. government will almost certainly have to reissue debt to replace most of that $5.2 trillion within three years.

There is a similar issue in the private debt markets. $200 billion of investment-grade credit will mature in 2013 and $150 billion in 2014. The situation is more ominous for low-grade bonds. $400 billion of existing high yield (junk) debt comes due in 2014 (Source: Kiplinger’s, “Tough Times Ahead for Junk Bond Issuers”). Most of the maturing debt is likely to be replaced by new debt coming to market just as the government looks to re-issue its own offerings. Some companies with junk bonds may not be in a position to refinance, forcing a deferral of repayments or, in extreme cases, default. Buyers may be in a strong bargaining position, forcing yields higher. That will hurt the bottom line of existing holders of bonds and bond funds.

Corporations taking the other side of the trade
These are times that heavily favor the borrowers, not the lenders. America’s corporate Chief Financial Officers are doing something that seems counterintuitive. Despite the fact that many firms are sitting on record levels of cash, waiting to find a reason to put it to work, some are borrowing as well. September issuance totaled $159 billion, according to Bloomberg. That’s more than any September in history. What these CFOs have figured out is that debt is cheap at today’s rates. Microsoft, with an estimated $26 billion in the bank, issued $4.75 billion of three-year notes paying less than a 1% yield. IBM, already sitting on $12 billion, issued three-year notes yielding just 1%. These are among the many examples of corporations tapping the debt markets for even more cash. And why not? The rate is so low, debt owners will receive a return that is almost certain to be negative on an after-inflation basis. Corporations seem to recognize that if they wait to issue debt down the road, they will almost certainly pay higher rates.

The Fed is positioned to become bondholders’ worst enemy
Although written in the Federal Reserve’s typically fuzzy style, this September 21 statement seemed clear to many in the market:

Measures of underlying inflation are currently at levels somewhat below those the committee judges most consistent over the longer run, with its mandate to promote maximum employment and price stability.

The Fed’s “mandate” is to target an inflation rate of 2%. This statement, combined with Fed Chairman Ben Bernanke’s own comments in a speech in Jackson Hole, Wyoming on August 27, makes clear that the Fed will do what is necessary to bolster the economy. The market continues to speculate that phase two of its Quantitative Easing strategy (commonly referred to as QE2) is inevitable. Since the Fed Funds rate basically can’t go lower (currently at 0.25%), this will require keeping the printing presses busy churning out more currency (a.k.a., currency debasement).

Veteran market analyst Dr. Edward Yardeni says the Fed is focusing on reducing the unemployment rate. But he thinks the more likely outcome of QE2 will be “a bubble in commodity markets and the stock markets of emerging economies.” Yardeni already sees signs of this just in what happened since the Jackson Hole speech. From August 27th to October 7th, we’ve seen the following jumps in prices:

  • Crude Oil +10%
  • Gold + 9%
  • Copper +12%
  • U.S. Stocks + 9%
  • Emerging Markets Stocks +14%

In the meantime, a virtual currency pricing war is underway around the globe. China has been playing this game for years. Japan has been actively pursuing a currency devaluation effort, and European nations are getting involved as well. The goal of debasing currency is to help stimulate growth (through improved exports) and perhaps some inflation, which will help diminish the impact of large deficits.

The combination of rising inflation and continued debasement of the dollar contributes to what is already shaping up as a hostile environment for bonds.

What could be lost in bonds?
With 10-year Treasuries yielding around 2.5% and 30-year bonds about 3.75%, there isn’t much room for rates to decline. Much more obvious is the downside risk. If, for example, the yield on 30-year bonds jumps to just 5% (still very attractive by historical standards and where rates stood in the summer of 2007), it would represent a loss in value for current bondholders of more than 17%. If rates continued to trend higher, the losses would be even greater. If 30-year rates move to 7%, investors in 30-year U.S. Treasury bonds could see the market value of their bonds drop by close to 40% from their current value – a level of principal instability that most bond holders were trying to escape in the first place.

This is the type of downside risk that is easily overlooked by bond investors, who focus in on the fact that bonds held to maturity will maintain their value. That’s true, but in order to do that, an investor will also have to be content to accept yields of less than 4% (for the duration of a 30-year bond) while inflation slowly erodes purchasing power year-after-year, causing each dollar to be worth less.

What’s more, those investing in bond funds have almost no control over whether the funds will sell their bonds as interest rates increase. Thus risking their principal investment.

Focusing on the road ahead
“The U.S. economy remains almost comatose…The current slump already ranks as the largest period of sustained weakness since the Great Depression…Once-in-a-lifetime dislocations….will take years to work out. Among them: the job drought, the debt hangover, the defense industry contraction, the (banking) collapse, the real estate depression, the health-care cost explosion and the runaway federal deficit.”

Much of the fear driving money into bonds is tied to an environment that has many concerned the U.S. economy may be facing the start of a long, slow decline. If you thought the above describes our current state of affairs, think again. It is taken from a Time magazine article from 18 years ago summarizing the dismal state of the U.S. economy (Time September, 1992). What followed was an eight-year period of strong economic growth, a new technology revolution, a steadily improving housing market, a stronger financial sector and, believe it or not, a balanced federal budget.

Today’s circumstances may be somewhat different from those of 18 years ago. But like then, the pessimists seem to be looking in the rearview mirror. It is not hard to find reasons to be negative about the future based on all of the bad news we’ve heard in recent years, but Prof. Siegel points out that pessimists are overlooking some key economic indicators. He thinks naysayers are overly focused on factors that affect short-term economic growth such as consumer spending, business investment and government spending.

What many overlook are two factors Prof. Siegel believes will have a bigger impact on economic growth and, ultimately, investment potential for equities:

• Rising productivity – in the past decade, productivity has risen at an average of 2.7% per year, 0.5% higher than normal.
• Favorable global demographics – as he pointed out in his address to our clients at our 2006 MPMG Speaker Series event, concerns of an aging population are offset by dramatic population growth (and younger demographics) in emerging markets, which comprise 85% of the world’s population. Those markets, with a growing middle class, will have demands for goods and services.

Weighing Your Options
We’ve pointed out the following issues that need to come into play in your investment decisions:
• The psychology of fear has been overplayed in today’s environment.
• Inflation and continued debasement of the currency will, over time, erode the purchasing power of savings.
• Long-term trends such as productivity growth and booming global demographics will create a favorable environment for future economic growth.

With those points in mind, consider the position of the four broad asset categories for long-term investments:

  • Bonds, as described above, face significant hurdles. Not only is upside potential limited, but downside risk is significant.
    Real estate continues to search for a “bottom,” but heavy foreclosure volume and vast overbuilding in the past decade has resulted in a terrible oversupply problem. It isn’t likely to improve anytime soon.
  • Hard assets from gold to oil to copper should benefit if inflation returns. Even with its recent price run-up, gold is far from reaching its inflation-adjusted peak. What’s more, according to market analyst Donald Luskin, “the excess quantity of money (i.e., the Fed’s quantitative easing policy) mandates the revaluation of money substitutes such as gold,” which he believes gain in value as a result of these policies.
  • Equities are better positioned than bonds or cash. Ownership of assets (such as companies that can capitalize on growth opportunities) will benefit investors.

The value divergence between stocks and bonds today is significant. Prof. Siegel told an interviewer on Bloomberg TV “I’ve never seen such favorable valuations of stocks versus bonds. I’ve seen cheaper stocks – we’ve seen stocks (trading at) single digit P/E ratios. But relative to the bond market, you have to go back to the 1950s to get a similar situation.”

To demonstrate, consider what happened after bonds out-performed stocks over ten-year periods of time:

Investors today can earn a higher current yield from owning certain stocks than if they invested in government bonds. According to Boyar’s Intrinsic Value Research, 138 stocks in the S&P 500 and 17 of the 30 components of the Dow Jones Industrial Average pay a higher yield today than 10-year Treasury notes. Stocks certainly aren’t backed by the full faith and credit of the U.S. government, so the question then becomes whether the upside potential for stocks outweighs the downside risk.

In fact, a number of companies have issued long-term debt at yields lower than the current dividend yield of their own stock. Johnson and Johnson, for example recently sold 10-year notes with at a record low interest rate of 2.95%. In the meantime, the dividend yield on its stock is approximately 3.5%, far more attractive than what the company pays on its most recent bond issue (and this from a company with a long record of increasing its dividend over time.)

Well-managed companies that can take advantage of continued worldwide economic development are able to capitalize on the growth potential that is particularly evident in emerging markets. Yet many of their stocks are trading at prices comparable to where they stood at the turn of the millennium. An investor looking forward should recognize that real appreciation potential exists for those with a long-term perspective.

No fear
The fear that has dominated the markets since the financial crisis and onset of the recession may be close to running its course. That’s not to say greed should or will immediately replace it. Rather, it could be a time when investors will benefit from greater balance. There is an opportunity to capitalize on real value and focus on companies that can deliver results over the long term in evolving opportunities around the globe. It is not too bold to suggest that over the next decade, you will be happy to have owned assets that can capitalize on the world’s economic growth rather than to have lent your money to the government for a 2.5% annual yield.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.