Valuation matters
One of the most important principles in investing is that valuation matters. Even the best company can be a bad investment if purchased at too high a price, and even the worst company can be a good investment if purchased at a low enough price.
In my recent post about the current valuation of the S&P 500 I calculated that the index was overvalued by 60%+. As I showed in my analysis in that post, buying an asset at an inflated price, even if the asset performs well, guarantees low returns in the future.
Over the course of my 20 years investing career I’ve seen a number of bubbles. First there was the Dot Com bubble of the late 1990’s. Next was the real estate bubble of the mid/late 2000’s. Today we have the bond bubble, and it will end exactly as the previous bubbles ended – poorly.
The current bond bubble
Bonds should be naturally resistant to bubbles because bonds are fundamentally different than stocks. Stocks have unlimited upside. Companies generally become more profitable over time and their stock prices rise accordingly. Companies and stock indexes set all-time highs on a regular basis, and these highs are not necessarily a reason to stay away from stocks. Bubbles form in assets like stocks and real estate because we can imagine the price continuing to go higher forever. There’s no limit on the potential future price of an individual stock or the stock market in general.
Bonds, on the other hand, have very limited upside. If things go perfectly you get your biannual interest payments and your money back when the bond expires. The return on a bond depends almost entirely on interest rates – the rate when you buy the bond and, if you sell the bond before it expires, the rate when you sell.
But more importantly, bonds trade in a range. Since 1871 the 10 year Treasury has traded in a range from a high of 15.32% (September 1981) to a low of 1.50% (July 2016). As of August 31, 2016 it was at 1.58%, only 8 basis points above its all time low. Rates go up and rates go down but generally have traded in a relatively narrow band. If you look at this chart of interest rates over time you’ll see that for most of the last 140 years the average yield on the 10-year Treasury was just over 6%. Today the yield is 75% lower than its long-term average. Bonds are the most expensive they’ve ever been! How does this affect our expected returns from bonds?
Well, if interest rates don’t change (or if we hold the bond to expiration), our return will be the yield on the bond. Today that’s 1.58%. To reiterate – if you’re buying a bond today you’re locking in historically low yields for the life of the bond. The long-term average for inflation is around 3%. This means you’re locking in returns at 1/2 the rate of inflation. You’ll be getting poorer every year after inflation.
What if interest rates change? If interest rates go up, the value of your existing bond drops. If interest rates drop, the value of your existing bond goes up. Given that bonds are at a historical low, what do you think is more likely to happen – interest rates moving towards their historical average or interest rates continuing to go down and setting new all-time lows? Yes, it’s possible that rates go down. Some counties are paying a NEGATIVE yield. It’s MUCH more likely that over the next 5 years we’ll see substantially higher rates than today.
Buying bonds at today’s historically high prices means locking in pitifully small interest rates and guaranteeing a loss of principle as well.
So who is buying bonds at these rates?
Some entities are required to own bonds. Pension funds have minimum required bond holdings. Insurance companies are required by federal regulations to have a very conservative investment mix, which results in the average life insurance company having >70% of its investment portfolio in bonds. Entities like this are FORCED to buy bonds, regardless of the price.
Individual investors aren’t forced to do anything. And ff you’re not forced to buy bonds then you should not buy them at todays’ prices. In my opinion, nobody should own bonds today. I am recommending ZERO bond ownership for all investors.
Yes, I understand that there are people who think they need to own bonds. However, what these investors really need is some stability in their portfolio. These investors believe they are investing in a “safe” asset class by putting their money into bonds.
They are wrong. They are setting themselves up for disaster.
Buy CDs instead of bonds today
I do understand the need for stability in a portfolio. However, that stability does not need to come from a bond. A superior alternative today is to put your money in CDs. A quick search of interest rates on 5 year bonds shows a number of options with rates between 1.5% and 2.0%. With CDs you can get a better interest rate AND lock up your money for less time than with a 10-year Treasury.
Treasuries are considered “riskless” because they are backed by the full faith and credit of the US government. CDs should be considered the same – your total deposits (savings, checking, CDs, etc.) at each bank are insured up to $250,000 by the FDIC. The FDIC is explicitly backed by the US government. It has the same guarantees as US Treasuries. If you have a large portfolio of $1M and want to take advantage of FDIC insurance you’d just spread your money between 4 CDs at different banks. You now have four $250,000 CDs and all your money is insured by the US government. It’s as safe as money in a 10-year Treasury, but the big difference is that interest rate changes will not affect the value of your CD.
One big difference between CDs and bonds is that bonds pay interest twice a year and CDs pay the interest at the end of the term of deposit. This can be addressed by setting up a CD ladder. You put 20% of your “safe” allocation into a 6-month CD, 20% into a 1-year, 20% into a 2-year, 20% into a 3-year, and 20% into a 5-year. You then have a chunk of cash coming in at regular intervals. At each CD expiration you can take out what you need (if any) and reinvest the rest into another CD ladder. The average interest rate will be a bit lower this way than it would be if you just bought a 5-year CD, but then again, you’re taking on no interest rate risk.
Conclusion
The fact that interest rates generally trade in a relatively defined band means that bonds are a bit more predictable than stocks. When you’re at an all-time low (or all-time high) in interest rates, the chances of a reversion to the mean are higher than the chances of hitting lower lows or higher highs. Since nobody can predict the future, the best we can do is play the odds. We don’t know when rates will go higher, but we know they will.
If you have bonds – sell them. If you’re thinking about buying bonds – don’t. Put your money in CDs instead. You’ll get a similar interest rate (depending on the length of the CD) with no interest rate risk.