Bond: The Little 4 Letter Word Investors Hate To Use

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Includes: FRT, FTR, GHY, PM, TK, WYNN
by: Adam Aloisi

Summary

The predictions of demise in the bond market continue to be wrong.

The current risks involved in bond investment.

What has to happen for a bond bubble to actually exist today?

Current bond strategy and some ideas.

Should you own bonds at all?

In a Wall Street Journal article last month, famed hedge fund manager Julian Robertson was quoted as saying, "Bonds are at ridiculous levels." He also stated that the bond market bubble will end in a very bad way. In the same article Oaktree Capital Chairman Howard Marks opined that bonds are "very overvalued."

Those who follow the bond market should know that these "bubblish" kinds of descriptive phrases are nothing new. They've been heard in full force for over six years now, basically since the onset of the '08-09 financial crisis. Of course those uttering slighting bond market comments have been wrong for, well, six years now.

What I typically find so bothersome about generalized negative bond commentary is that it usually takes little into consideration about the complexity and heterogeneity of the asset. There's a big difference in the risks being assumed and potential existence of a bubble when one is looking to buy an investment grade bond with near-term maturity versus a longer-term Treasury.

Still, it's difficult to argue the fact that a rising rate environment, which the bond bears continue to pound the table on, would be a deleterious event for those holding most bonds. If a portfolio of bonds is skewed towards issues with 20-30 year maturity, then yeah, that portfolio is taking on a tremendous amount of rate risk, assuming rates do ultimately rise.

Yet if another bond portfolio holds short- and intermediate-term paper, or is already well laddered with reasonable blended duration, the risks are generally much lower, even in a rapidly rising rate climate.

A Multitude Of Bond Uses And Risks

Bonds, historically, have been looked at as a dual purpose investment vehicle. Combining capital preservation and income generating characteristics, bonds are typically viewed as the middle ground between cash and equity investments. However, over the past 30 years due to the steadily declining interest rate environment, bonds have been a capital appreciation vehicle as well.

Though credit and duration aspects vary from bond to bond, for the investor who commits to buying and holding a bond until maturity, there is no capital risk, except in the event of issuer default. Interim opportunity cost could be viewed as a risk for the investor who buys a low coupon bond and sits with it through a rising rate environment. Further, if one changes their mind on holding a bond to maturity in a rising rate environment, they may experience sticker shock on how little it will bring in the open market.

So again I point out the fact that there's a huge difference between an investor looking at bonds as a capital preservation and prudent income tool versus someone looking at them as a trade on the near-term interest rate environment or as an income maximization tool.

Are We Really In A Bubble?

If you think we are in a bond bubble, you need to believe a number of things. You need to believe that the Fed will exit QE unscathed and that there will be no lagging effects. You also need to believe that over the next few years the economy steadily improves and that the Fed will begin a tightening spree that spans several hundred basis points.

I would argue that economic fundamentals are currently stable but not robust. The middle class is struggling and it will take more time for the housing market and banks to return to a pre-crisis equilibrium. While popular consensus seems to be that the Fed will tighten next year, my guess is if it actually happens, it will be a quarter point and nothing more. So personally, I'm finding it hard to believe that there is anything catastrophic headed the bond market's way.

In the month since Robertson and Marks issued their recent salvos against the bond market, the 10-Year Treasury has actually dropped 25 basis points, as global instabilities and a volatile stock market created a flight to quality. While time will tell, they may be just two more in a long line of pundits who've inaccurately predicted the demise of the bond market.

Strategy Session

Despite my general thesis that rates will remain lower longer than most seem to believe, I still think bond buyers should keep maturities on the short-to-intermediate side and credit quality high - in the BBB/BB "area." I did a search on Fidelity's web site for current ideas and came up with the following investment grade pieces:

An 8-year piece of Wynn Resorts (NASDAQ:WYNN) can be had for better than 4.5% yield and if you go out 13 years you can get Phillip Morris (NYSE:PM) paper for better than 5 percent.

If you want to be a bit more daring on the credit scale, here's some ideas:

If you want to go 6 years out Teekay (NYSE:TK) has a roughly 6% offering, and if you go out 5 years further, you can buy Frontier (NYSE:FTR) for almost 6.75 percent.

While I'm generally anti- bond funds, I don't think they are a bad idea for high-yield investors, given the instant diversification they provide. An aggressive, leveraged idea that keeps duration short but has a current yield in excess of 9%, is Prudential Global Short-Duration (NYSE:GHY), a closed-end fund selling at nearly a 10% discount to net asset value. It's somewhat of a contrarian call that fits a niche for the diversified, risk tolerant, income investor.

Should You Own Bonds At All?

Bonds add diversity and stability to a portfolio made primarily of equities. How much or how little they are utilized is a matter of preference, risk tolerance, and what role they play in a personal portfolio. With rates as low as they are, the income benefit of owning bonds today is certainly much less than it was a decade ago. And if you choose to believe that it will be off the rate-tightening races over the near-term, it might be best to avoid them altogether. But retail investors are usually lousy market timers.

I first started buying bonds rather heavily during the technology boom of the late 90s when growth stock and general equity valuations were stratospheric. Of course this was back when a 10-Year Treasury could be bought for better than 6%, and investment grade corporates for even higher than that. Now you get a paltry 2% on the 10-Year and have to take some credit and/or duration risk to get to a 6% bond yield.

Over the years I've migrated a lot of my bond holdings over to equities as the risk/reward spread between the two narrowed. I certainly am not a bond pusher, but for many investors, the stability, income generation, and risk mitigation role that they provide makes them a worthy consideration, if only for a small portion of the portfolio.

At some point rates will rise again and fixed-income will regain full-fledged allure with the investment community. Until that time, investors who are able to prudently manage credit and duration risks should find niche value in owning a targeted portfolio of bonds, despite what the bubble blowers have to say.

Disclosure: The author is long WYNN, GHY, PM.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.