The Riskiness of Bonds

Yesterday I questioned the wisdom of retail investors buying bonds in this market, and boy did I get an earful back, especially from many of the commenters at Seeking Alpha. They accused me of not drawing the distinction between Treasuries and credit, and of not appreciating the record spreads being seen in the bond market.

This morning, Henry Blodget gives us a useful chart, showing that the Lehman Aggregate bond index -- which is the benchmark for most of the bond funds that retail investors buy -- rebounded sharply in the last two months of this year, and ended solidly in positive territory. Which is quite an achievement for any asset class in 2008.

Now yes, the rebound is largely a function of the Treasury bubble -- but so are record spreads in the credit market. And since retail investors don't short Treasury bonds, they can't play spreads. Instead, they have just three choices: going long Treasuries; going long credit; or some combination of the two.

Clearly the Treasury market is treacherous right now, and could implode as quickly as it rose. I can assure you that this kind of chart (from a very useful blog entry by Richard Shaw) is not the kind of thing that dealers in US debt ever expect to see:

Yes, that's a 35% annual return on long-dated Treasury bonds, in a year which started with pretty low interest rates. So clearly anybody buying Treasuries right now is doing so at extremely frothy levels.

But what about credit? The flip side of Treasury outperformance has been a collapse in prices of credit, and in general the riskier the credit, the more it has fallen. Junk bonds and emerging-market debt cratered in 2008, but the bulk of the bonds that retail investors are likely to buy -- US investment-grade corporate bonds -- actually staged quite an impressive rally at year-end.

If you believe that mid-October's bond-market panic was overblown and that we'll never see such levels again, then feel free to dip a toe into this market. But if you do so, be clear that you're entering into a speculative trade:You're not putting your money in a safe place like an FDIC-insured CD. (And you can do that with any amount of money, not just $250,000, thanks to CDARS.)

But bonds certainly aren't any kind of hedge against stock-market underperformance. If the stock market goes down from its present levels, it will do so because of a wave of defaults wiping out the equity in a wide range of companies. The bond market is pricing in an uptick in defaults, but no one knows just how much of an uptick, and there's a very good chance that if a few large and heavily-indebted public companies go under in quick succession, the bond market could lurch back down to its October lows and possibly even fall further still.

None of this makes investing in bonds a bad idea for a sophisticated investor: they do seem to be more attractive, from a risk-return standpoint, than stocks, just as they have been since the summer of 2007. And there's a strong moral hazard play right now as well: There's a very good chance that Treasury will step in to prevent America's largest companies from going bust. But if you're looking for safety, cash is still very much your friend. And if you're investing in bonds, know the risks that you're taking.

Comments

[MarvinMBA:]

There's no better place to put your cash than FDIC insured CD's in my opinion. The next round will be inflation and Treasuries will be dropping like rocks so the next round will be to pick up some of those Treasuries after they bottom out and you will have the cash when the drop occurs to do so. ...MarvinMBA

Jan 02 12:59 PM

[Chris B:]

There are decade-long periods when bonds perform better than stocks, and this may well be one of them.

However, pigs get slaughtered in environments like this, so there's no reason to get greedy. Out of control charts, unprecedented deviations from long-term means, and earnings estimates that failed to factor in higher defaults: these were the warnings we had this time last year. Many people thought oil was a sure bet 6 mos. ago and they lost big time. When they got into stocks, they lost again. Now they're pumping up treasuries, on the verge of losing yet again. It all made sense at the time.

If I was to do anything, I would short treasuries using ETF's like TVT and PST (yes Felix, retail investors can easily short t-bills). After all, can treasuries really get any more expensive than offering a near-zero yield? Yes, we could be in for a Japanese scenario for a decade, but overpriced treasuries seem to be the only certainty.

As for corporate bonds, I would be very careful. If deflation is killed by our current massive monetary expansion and investors come to expect Paul Volker-1982-style rate increases in the near future to control the inflation that will result, those yields could be woefully inadequate. I would wait for higher yields to come and I would avoid many companies (most financials, retailers, consumer discretionary) whose business model have become obsolete in the coming world of 10% consumer savings rates.

Jan 02 01:22 PM

[swygert@law...:]

Felix, this time I agree with you on about every point, especially regarding being cautious about buing investor-grade corporate bonds of more than four or five years maturities. Your inflation scenario resulting from massive monetary expansion is credible, but I have one caveat: the timing of the deflation/inflation switch. No one knows, of course, but my guess. for what's its worth, is that the inflationary cycle will begin at more likely than not at least two years or three years out. So, money in investment grade corporates of three to five years do not to me appear to be putting one's capital in these assets at much risk. (Please, however, don't ask me about my AIG bonds).

Jan 02 01:51 PM

[2old2care:]

Chris B wrote:
"I would short treasuries using ETF's like TVT and PST"

I believe you meant TBT rather than TVT...

I think I'll buy more today. ;)

Jan 02 02:01 PM

[1977°C:]

Yes, T-Bones ( that's how I call Treausuries) look overbought but same can be said of Nasdaq or Dow Jones stocks or just any asset like value of your house or value of French perfume (I bought my girl 5 bottles 50ml of Thierry Mugler perfumes called MIRRORS in wooden mirror box, price 130$ per 50 ml bottle in Duty Free airport shopping) which is also crazy overvalued, so what?
I expect T-Bones to stay at current levels (30 years T-Bones futures range 116.5 - 144) as investors will keep counting equities losses and will run to buy bonds, yes it is crazy but already hedge funds go bust shorting bonds so don't try to time this market, keep away, I myself would enter shorts at 144 on 30Y Treasuries futures but with strict stops in place.

Jan 02 02:25 PM

[Anthony Alfidi:]

That wave of defaults is just around the corner. Debt-laden REITs are teetering on the precipice . . .

It seems that TLT makes sense as a short candidate for those of you so inclined. Just look at that chart up top.

Jan 02 03:59 PM

[Larry House:]

To remove all risk is to get next to nothing in return. That is ok for must-have money, one's cash reserve, but moving beyond that, risk increases as does return or potential return. Bonds certainly have their risks. I held Lehman bonds when that fine business went under. I and many others were betrayed by the rating agencies and others. However, in the overall scheme of things, good-quality bonds have RELATIVELY less risk than bonds. I respect your writings very much, Felix, but you are twisting your thesis from the original piece you referenced. I read it as well. No one can argue with your statement that bonds carry risks, no duh, but your previous argument was more general in denigrating bonds--not just from a risk perspective. Keep up the good work. Let this topic go, and move on to some other helpful topics.

Jan 02 07:38 PM

[fixed incom...:]

I think there is another important consideration.

Investors with long-term horizons / goals / retirement effectively are short the long-term time value of money. Someone in this category can reduce their risk by buying long term bonds to hedge their "liability". If you were a pension plan with long term future benefit payments and you did not own a significant allocation of longer bonds, the recent move in bonds may have caused you to become underfunded (even more underfunded if you were in equities instead). So in this circumstance, owning long term bonds is a risk reducer. Not owning them exposes the investor to further loss if rates continue to fall.

Jan 02 08:51 PM

[fixed incom...:]

I think there is another important consideration.

Investors with long-term horizons / goals / retirement effectively are short the long-term time value of money. Someone in this category can reduce their risk by buying long term bonds to hedge their "liability". If you were a pension plan with long term future benefit payments and you did not own a significant allocation of longer bonds, the recent move in bonds may have caused you to become underfunded (even more underfunded if you were in equities instead). So in this circumstance, owning long term bonds is a risk reducer. Not owning them exposes the investor to further loss if rates continue to fall.

Jan 02 08:51 PM

[Dr.Jackpot:]

BETTER THAN GOLD !

Hand made knives by well known artist. I bought a hand made knife by 'Randall' in Florida in 1959 for $25. Today that same knife is offered on Ebay for $1,500. So the tax free compounded return over 50 years has been 8.5% annually. An ounce of gold would be $1,091 to match that (starting from 1967 I believe).

Jan 03 09:16 AM

[freefall51:]

Those investment grade corporate bonds can turn on a dime.
Look at LyondellBasell, one of the world’s largest companies for plastics, chemicals, and fuels.
Over extended debt for the merger $12.7 B, cannot be served in economical downturn.
Rating downgrade by S&P and Moodys earlier in Dec to selective default. Then press release, company considers filing for Chapter 11 on Dec 31, 08.
Lyondell bonds sell now for 11.5 c on the dollar. It costs $ 8.5 M to insure a $10 M loan over the next years. BAM!
Here is an idea. Other than going for high yield bonds, screen companies for high debt/ equity and short the hell out of them.

Jan 03 10:30 AM

[snake driver:]

Happy New Year folks,

Chris B said:

"If I was to do anything, I would short treasuries using ETF's like TVT and PST (yes Felix, retail investors can easily short t-bills). After all, can treasuries really get any more expensive than offering a near-zero yield? Yes, we could be in for a Japanese scenario for a decade, but overpriced treasuries seem to be the only certainty."

This seems like airtight logic to me. If treasuries have nowhere to go but one direction, how could one go wrong with Chris B's strategy? Can anyone describe a scenario in which Treasuries go the other way?

Jan 03 10:46 AM

[John Lounsbury:]

Chris B and snake driver - - -

I agree that shorting treasuries is looking attractive. However, using TBT has high potential risk.

Answering snake driver's question (Is there a scenario where treasuries continue to go up ?) reveals the risk. One such scenario is that the three-day stock rally fizzles, stocks move lower in the coming several weeks, and the November 20 bottom fails to hold. That could prompt a further flight to safety and more dollars piling into treasuries.

On January 2, the U.S. Treasury web site reports that the 20 year treasury yield closed at 3.22. If a further flight to safety were to drive the yield down to 1.6%, $1000 invested at the close on January 2 would drop to $500. The leverage for interest rate changes to price increases as rates get very low. If you use TBT, you multiply the leverage by two. So buying TBT at the Jan 2 close of 39.00 could see the price drop to as low as 9.50 to 10.00 if the 20-year yield dropped to 1.6%.

On the up side, if the 20 year treasury rises to the 4.8% area, TBT will approximately double.

I use the word approximately because TBT has the objective of tracking double the price moves on a daily basis and price changes over longer time periods of time suffer tracking errors which can accumulate.

Disclaimer: I am down approximately 30% on my TBT position entered about two months ago.

Jan 03 12:29 PM

[mplaut:]

The problem is that those ETFs are composed of future instruments and they lose money every month when they have to roll them over. So if you buy now they could deteriorate over time before the T-bills turn around. "The market can stay irrational longer than you can stay solvent."

Jan 03 12:53 PM

[snake driver:]

I think I have been learning that painful lesson with SRS over the past few weeks. IYR goes nowhere, but SRS goes into the toilet bowl. What's the use of being right about real estate if you can't make money from it?

Jan 03 07:00 PM

[Kunst:]

The next round of inflation isn't going to make your 3% CDs a very good investment either.


On Jan 02 12:59 PM User 118015 wrote:

> There's no better place to put your cash than FDIC insured CD's in
> my opinion. The next round will be inflation and Treasuries will
> be dropping like rocks so the next round will be to pick up some
> of those Treasuries after they bottom out and you will have the cash
> when the drop occurs to do so. ...MarvinMBA

Jan 03 09:44 PM

[Kunst:]

The problem is that inflation will come from massive printing of money by the Fed to avoid having to pay sharply higher interest rates on treasuries, which are going to be issued in record quantity over the next few months and quarters. It could happen a lot more quickly than you might expect.


On Jan 02 01:51 PM bocaj21 wrote:

> No one knows, of course, but my guess. for what's its worth, is that the
> inflationary cycle will begin at more likely than not at least two
> years or three years out. So, money in investment grade corporates
> of three to five years do not to me appear to be putting one's capital
> in these assets at much risk. (Please, however, don't ask me about
> my AIG bonds).

Jan 03 09:47 PM

[Kunst:]

On Jan 03 10:46 AM snake driver wrote:

> This seems like airtight logic to me. If treasuries have nowhere
> to go but one direction, how could one go wrong with Chris B's strategy?
> Can anyone describe a scenario in which Treasuries go the other way?

Here's one: The Fed buys treasuries with newly created money. Higher demand means higher price = lower rates. No one can force interest rates up if the Fed keeps buying treasuries. That's the benefit of having your debt in your own currency.

Don't be too sure it couldn't happen.

Jan 03 09:54 PM

[Kunst:]

Repeat post, but I think worth it:

These ultra & ultrashort ETFs are extremely dangerous if you hold them for any length of time. Run some charts and you will see.

Examples, 1/1-12/29/08:
China: FXI and FXP are both down 50%.
Oil industry: DUG is down 25% and DIG is down 75%.
Financials: UYG is down 85%, SKF is up 25%.
Real estate: URE is down 80%, SRS is down 45%.

DOG (ProShares 1x short Dow 30) is up 20%, DXD (same except 2x) is only up 15%. The single-leverage did better than the double!

If you hold on to these ETFs for more than a few days, you are on a losing track. Beware!



On Jan 03 07:00 PM snake driver wrote:

> I think I have been learning that painful lesson with SRS over the
> past few weeks. IYR goes nowhere, but SRS goes into the toilet bowl.
> What's the use of being right about real estate if you can't make
> money from it?

Jan 03 09:56 PM

[NYCDart25:]

But where does that money come from? The Fed does not effectively "create" money by printing it, at least not in bulk, they just buy and sell debt. So they are not, in the long term, going to sell debt to finance themselves buying back more of their own debt...


On Jan 03 09:54 PM Kunst wrote:

> On Jan 03 10:46 AM snake driver wrote:

Jan 04 04:36 AM

[User 334076:]

test


On Jan 02 12:59 PM User 118015 wrote:

> There's no better place to put your cash than FDIC insured CD's in
> my opinion. The next round will be inflation and Treasuries will
> be dropping like rocks so the next round will be to pick up some
> of those Treasuries after they bottom out and you will have the cash
> when the drop occurs to do so. ...MarvinMBA

Jan 09 04:24 AM

[User 334076:]

test


On Jan 03 09:44 PM Kunst wrote:

> The next round of inflation isn't going to make your 3% CDs a very
> good investment either.

Jan 09 04:25 AM

[User 334076:]

test

On Jan 03 09:54 PM Kunst wrote:

> On Jan 03 10:46 AM snake driver wrote:

Jan 09 04:25 AM