The popular media's focus on equities, and the certainty that all bond yields are destined to rise, can cause investors to overlook important opportunities in fixed income. In addition, using simple reference points such as 10-year Treasury yields oversimplifies fixed-income markets, and ignores many attractive investment alternatives. While U.S. Treasuries may be at unattractively low yields, the fixed-income markets still offer many interesting opportunities for investors seeking a highly predictable and reasonably generous return (of and on) capital. These opportunities will become increasingly scarce as deleveraging reduces the supply of high-quality fixed-income securities available to investors. In addition, there is strong historical evidence that we are closer to the beginning than to the end of the current cyclical interest rate trough.
At the end of this article, I will provide some examples of where investors can find value in the bond markets. More immediately, I present the case that it is not crazy to buy bonds in the current environment by presenting a series of historic graphs. First, consider the graph below, which I used in a previous article.
Click to enlarge images.
I drew two conclusions from this graph:
- Tighter monetary policy, generally in the form of increasing the federal funds rate, has been a necessary -- but not sufficient -- condition for recession since 1950. In fact, this has been true since the founding of the Federal Reserve.
- Up until 1980, higher increases in the federal funds rate were required to induce recession. But, since 1980, recessions have been induced by lower incremental increases in the federal funds rate.
A principal reason for the second phenomenon is that a rapid increase in total leverage in the economy relative to GDP since 1980 (shown in the graph below) has magnified the impact of any given increase in short-term rates.
A corollary to the proposition that higher overall leverage means lower interest rate increases induce recession is that until leverage is significantly decreased, there is a ceiling on interest rates. Any meaningful increase in rates while debt levels remain at high levels is likely to intensify deflation, depress long-term yields, and invite the Fed to keep short-term rates low.
The next graph shows that the increase in leverage through the last recession exceeds anything experienced in the U.S. since at least 1870, including the great leveraging associated with the Great Depression.
An important conclusion from the last graph is that, if history is a guide, debt as a percentage of GDP will decline significantly over the coming years. If we repeat the pattern of the last great deleveraging, this reduction in total debt could take close to 20 years before we reach the low point in total debt to GDP.
As debt becomes more scarce, one would expect bond prices to rise -- which is to say, bond yields to fall. Indeed, the graph below of long-term bond yields in the U.S/ since 1790 shows two recent peaks in bond yields in the 1920s and around 1980, with the last trough lasting from about 1940 to 1950. This 10-year trough in long-term bond yields roughly corresponds to the last 10 years of the last great 20-year deleveraging cycle, discussed above.
If total leverage reverts to historic means, and the impact of this falling supply of debt on bond prices follows historic patterns, long-term interest rates could stay low for longer than many investors anticipate. Concern that the Fed will stop buying Treasuries and mortgages should not deter investors from considering all fixed-income alternatives. The current market offers careful investors a wide array of opportunities to be adequately compensated while preserving capital and achieving highly predictable returns.
For example, fear and confusion fostered by Detroit's filing for Chapter 9 and Puerto Rico's budgetary challenges have created significant opportunities in the municipal bond market. AA-rated tax-exempt Detroit Water and Sewer bonds, insured by Assured Guaranty due in 2017 and 2019, recently traded at yields in excess of 5%. General Obligations of the Commonwealth of Puerto Rico as well as many of its agencies offer exceptional value, with yields ranging from 7% to 10% depending on the credit and the maturity. Puerto Rico is not eligible to file bankruptcy, so the risk of a "cram down" in Chapter 9 is not a threat to bondholders. The Commonwealth's obligations are governed by the Territory's constitution, which provides unambiguous protection to bondholders, including a requirement that all Commonwealth revenues must go first to pay General Obligation bondholders.
Commentators often disparagingly compare fiscally challenged governmental entities to private businesses, but of course the reason bonds issued by governments and their agencies are so secure is that they are not private businesses. They have taxing powers and monopolistic controls over their markets that make them nearly impervious to bad management. The aggressive use of Chapter 9 by Jefferson County, Stockton, and Detroit has opened a new chapter in municipal credit. In past fiscal crises, New York, Cleveland, Bridgeport, and many other distressed cities ultimately paid their bondholders in full whether or not they missed a debt service payment. Investors now need to be wary of any city or other subdivision of a state availing itself of the opportunity to "cram down" bondholders in a bankruptcy filing.
However, it is possible to mitigate or eliminate the risk of Chapter 9. For example, states and certain other issuers -- including Puerto Rico and its agencies -- cannot file Chapter 9. Many states preclude their subdivisions from filing Chapter 9. In addition, bond insurance on lower credit quality bonds may protect the investor for at least the next 10 years. Other than Assured Guaranty, most bond insurers are no longer rated by the rating agencies. However, some of these insurers are paying claims and are likely to continue to do so for at least several years. Buying shorter maturities with insurance from some of these entities is a reasonable way to achieve higher yields without risking loss of principal.
Another interesting category of bonds investors may want to consider is debt issued by non-profit hospitals. High levels of bad debt expense, resulting from treatment of uninsured patients, have plagued hospital finances for many years and have been a major drag on hospital credits. Quite often, these entities are otherwise reasonably strong credits with monopolistic characteristics in their service areas. The individual insurance mandate in the Affordable Care Act should reduce bad debt expense for many hospitals as more patients have insurance. This recovery will not be immediate, but a measurable improvement over a two- to three-year period in the financial condition of many of these institutions seems likely. In the meantime, it is possible to buy tax-exempt hospital bonds with yields ranging from 5% to 9%.
We are in the last stages of a 33-year bull run in long-term bonds. However, this stage may last longer than many anticipate. Investors should be careful not to write off all fixed-income yields as too low before investigating the available alternatives to U.S. Treasuries. Compared to a long-term average pre-tax return for equities of something like 8%, highly predictable after-tax returns ranging from 5% to 8% with return of principal on a date that's certain can represent attractive alternatives, especially as equities approach full valuation.