The investment highway is littered with those who have incorrectly forecasted the impending rise in interest rates. In May 2009, Niall Ferguson of Harvard declared that the “tidal wave of debt issuance” would cause U.S. interest rates to soar. In April 2010, an article written by Mark Gongloff in the Wall Street Journal detailed the 10-year Treasury forecasts among the primary fixed income dealers for year-end 2010. Rates were hovering at 4.0% at the time the predictions were cast and the median forecast was for a rise to 4.2% by year-end 2010. But they didn’t. Rates finished that year at approximately 3.2%. During that same year, the influential stock picker David Tepper, among many other sophisticated stock investors, also thought that bonds were then a bad investment. They were equally as wrong. Then there’s last year when the “Bond King” (PIMCOs Bill Gross) himself was caught on the wrong side of the trade as he shorted Treasuries in an expectation that interest rates were heading higher. The outcome is now well known—10-year Treasury rates slid from the 3.5% range to the 2.0% range, resulting in an unusually bad performance year for Gross.
Over this past weekend in Barron’s, Doug Kass, the judicious stock picker and market analyst from the citrus state, added his forecast (link to the Pragmatic Capitalism take on this) that shorting bonds will be one of the best trades of the next decade. In other words, Doug believes that interest rates are heading higher. Only because of the fact that he’s a bit non-committal do I tend to agree. Ten years is a long time! I feel very confident that interest rates will rise drastically over that time period for a whole host of reasons including mean reversion, punishment for large deficits, and eventual global growth. However, I just don’t think that this will happen any time over the over the next 9 – 12 months (about the longest I’d ever personally venture to forecast) and that better entry points will exist later. So, currently, I’m not reducing a current overweight exposure (let alone shorting) to bonds in client accounts.
Before I get into this further, let’s quickly review a primer on the pricing of bonds. In simple terms, the price of a bond is determined in the same way stock prices are—by supply and demand. The more investors want a particular bond, the higher the price will be. The variables that drive the supply & demand of bond prices, however, are somewhat different than for that of stocks. The main variables include the credit quality of the bond issuer, the prevailing interest rates and the length to maturity. For example, a bond issuer such as the Federal government, with no history of default, can issue bonds at a lower rate than a corporation with a spotty credit history. So, by purchasing a bond the investor is assuming, and being compensated, some credit risk.
An important variable that bond investors need to be familiar with is interest rate risk. As interest rates increase, bond prices decrease. And because Doug Kass feels that interest rates will rise, he is shorting bonds.
It’s is important for anyone who’s in the business of managing money (whether it’s professionally or self-directed) to have an opinion on the future movement of interest rates. My opinion is that for the 10-Year U.S. Treasury rates to rise on a sustained basis we’ll basically need one, or both, of the following scenarios to occur: (1) an increase in growth, or (2) investors demanding higher rates. For the first, I’m just not sure the evidence exists showing substantial improvement in growth. Yes, stocks are hanging in there, but in a recent post we argued that this was for cost cutting reasons and the potential for further stimulus (link here). Housing is showing some signs of improvement, but anyone who thinks that the lift off from these bottoming levels won’t take years is living in a fugue state. Consumer price & producer price index numbers are coming down, indicating diminishing inflationary effects. And all-important employment and personal income are widely known to be basically flat. This is not to even mention the obvious problems overseas with EU and a Chinese slow-down. To argue that the global “de-leveraging” associated with corporate, government and household balance sheets is not deflationary, but inflationary, is a bit of a stretch.
As far as the second, investors demanding higher rates, well this opinion is debunked by the chart shown above. Believe it or not, there are many other countries that offer lower government yield choices than the U.S. No, this chart argues that there is the potential for further downside in U.S. Treasury yields given a continued choppiness in economic indicators. This is especially true when you consider that the U.S. is the “cleanest dirty shirt” (forgive me for using this much overused phrase, but it is appropriate at times).
Don’t get me wrong, I believe that stock exposure is necessary based on one’s own risk profile (see link), but that the two previous points of a lack of impetus for growth and U.S. government bond rates that are actually competitive, argue for a current overweight in fixed income exposure to clip interest coupons while we wait the de-leveraging to run its course.
I, you, all of us who actively manage accounts spend a lot of time in valuing stocks. Stock picking is very important. But asset allocation matters even more. It always has. Studies show that 90% of performance differential between diversified accounts depends on your asset allocation. And with correlations as high as they are now among risk assets (Pragmatic Capitalism), the allocation of one’s assets becomes that much more important.
In conclusion, there are certainly dangers in bond investing. Kass is correct in saying that rates will eventually rise, which will cause a lot of pain for investors who are neither nimble nor protected. Cullen Roche, in the Pragmatic Capitalism link, argues that ladders and diversification are needed components to one’s bond portfolio. I couldn’t agree more. To this I add stop limit orders on bond ETF positions. I also recommend a healthy dose of actively managed fixed income mutual fund exposure from a seasoned manager such as Jeffery Gundlach of DoubleLine. I’m confident in my bet that a rise in interest rates is not exactly around the corner, but it would be imprudent to expect that it won’t eventually happen. Investors must be nimble and vigilant in their risk management to avoid the destruction of capital that will eventually occur with the rise in interest rates.