Where from here?
With the markets trading at “all time highs” and investors scurrying to find alpha, much is being made about the demise of the bond market. Analysts and economists are in accord that the age of bond appreciation is over. The cause? Global austerity and national treasuries forcing (holding) interest rates down to their lowest levels in generations.
We know from quantitative studies that no trend is eternal. In fact most, if not all, market phenomena are cyclical, meaning they traverse a parabolic wave measured on an axis which either rises or falls. To that extent, my research corroborates the common thought that we have most likely seen the last gasp of capital gains from bonds. Does that mean that we know when, or if, the cycle inverts and yields start to rise? Not necessarily.
But because of these perceptions, not rules, the whole of the bond market is being thrown under the bus. While it is true that yields are down, total return from a well managed, diversified, laddered bond portfolio is still possible.
And yet, investors find themselves clamoring for “yield” from a variety of alternatives including ETF’s, limited partnerships, hedging, emerging market credit, and stocks. I, too, have advised traditional risk-averse clients that as bonds mature, or are “called-back” by their issuer, we must seek to augment baseline dividend and interest payments with newer, perhaps riskier, alternatives in yield oriented equities. If done prudently, it is a tradeoff worth the additional risks.
Being correct….or safe?
However, the market seems to have closed its eyes to the difference between theory and practical execution. Secular market changes take decades to effect. One can slowly rebalance risk in a portfolio without discarding an asset class outright. Besides, higher interest rates would be the best barometer of a bullish economy than any metric one might glean from new highs in the stock market.
Recall, that bond prices are not necessarily why we buy bonds in the first place. Yes, it’s great to buy bonds at a discount to par in a declining interest rate environment. However, that’s not where we are today. Clients who yearn for the 1990’s are stuck in a time-warp of unrealistic expectations. If yields do go up, the demand for bonds will be equally as great as that for stocks. The counter balance of rebuilding dividends in bond portfolios will more than offset the potential of declining prices in existing bonds held.
If the economy were to heat up (?), loan demand and rising rates would be part of a new landscape. It will take time to confirm these data, so please don’t think the “bond ship” has already sailed. Too often our 24 hour news cycle and access to information makes us think that we’ve missed out on the upside, or, worse, that a looming crisis is imminent. Such rash emotionalism is not worth jeopardizing one’s long-term portfolio construction. It’s never really “different this time”, nor do “feelings” ever meld well with mathematics and data analytics.
Wrong focus.
When assessing these new paradigms of yield it is best to have historical and cyclical data. Are these simply the best options at the present time or do we have valuable information to predict their performance during all possible sector, secular, and cyclical phenomena? I would argue that the current crop of alternatives are reputed to be of good quality but that they might have risks which we cannot quantify. For example, how many “bond funds” also have stocks in their portfolio? The idea that all of Wall Street is now looking at new alternatives for yield is anathema to our desire for empirical methodological consistency.
Preserving principal and generating portfolio gains are sometimes distant cousins. If a client expects “no risk” and loses money in a “secure” bond portfolio, their expectations are not being met. An early mentor of mine always reminded me that we are in the business of managing expectations just as much as we attempt to manage/create alpha. I still admonish clients to stay consistent in your discipline and to take a deep breath before jumping in the pool. Despite assertions to the contrary, hazard lies in trying to synthesize alternatives to traditional fixed income portfolios.
Scotty C. George
(212) 624-1147
The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete and it accuracy cannot be guaranteed. It is intended for private informational purposes only. Any opinions expressed are subject to change without notice. Du Pasquier Asset Management and its affiliated companies and/or individuals may from time to time own or have positions in the securities or contrary to the recommendation discussed herein.
© du Pasquier Asset Management
