Hi, it's Glenn Surowiec with GDS Investments. It's November 10th, 2016. Today I want to talk about something that I think every investor should be thinking about and that is how to prepare for higher interest rates. So rates today, let's use the 10-year as a proxy, but rates today are a little over 2% and they bottomed earlier this year at about 1.4%. And so the move from 1.4% to 2.10% is actually a very sizeable move in the bond market. There's a lot of factors that explain this and I won't touch on those factors today. What I want to do is give investors a game plan for how to prepare for what I think will be a very long cycle where rates continue to go up and this is not a one- or two-year phenomenon. It's more of a multi-decade phenomenon. So the current bull market in bonds started in 1982, so we're almost 35 years into a bull market and I think investors have been lulled into thinking that bonds "can't lose money." I hear that a lot from different investors, "Oh, you can't lose money in bonds," and I think it all depends on how you look at it. Certainly you can in real terms, but I also think that if you look at how investors make money from bond securities, there's essentially two sources. There's the current income, the yield. So in the case of the 10-year Treasury's you bought, the 10-year Treasury today, it's going to yield at about 2.1%. And the second component is capital gains or losses and that is dependent on what your bond yields relative to current interest rates.
So just to walk through a pretty vanilla example, if you bought a bond, let's say a 10-year bond 8 years ago and the yield on it was 5.5% and since then, rates have come down, you have a sizeable capital gain because you own a security that's providing a 5.5% yield in a market that is giving 2%. And that's essentially what's happened over the last several decades. So that second component, there's been a 35-year tailwind where bond investors have been able to capture both sources of return. Let's take a step back and imagine the psychological trap that most bond investors find themselves in after this multi-decade bull market. I mean, month in and month out, they are looking at their account, they're seeing returns, and they're sort of conditioned into thinking that bonds are a one-way bet. And if you look at history...and you have to look at the bond market, you have to look well before 1982 obviously...the bond market, like other assets, they're filled with cycles that are characterized by bear markets followed by bull markets followed by bear markets followed by bull markets. And I would say certainly what differentiates the bond cycle from other asset cycles is that bond cycles tend to be very long and from 1946 to 1981, bonds went from yielding 2% to over 15%, that's a very sizeable bear market for bonds. Again, 1946 to 1981. And then we talked about 1982 to 2016, it really took the opposite path, a strong bull market path. And as I sit here today, I don't know where the next 25 basis points is going, but long term, investors who are trying to get that next generational move correct should be much more concerned with rates going up than rates going down.
So what should investors do? I talked about this in my last mid-year client letter in July, but I think that we're only a couple months into this, so obviously the 10-year has moved and we talked about it. It bottomed earlier this year at 1.4%. It's obviously moved quite a bit to 2.10%. And like I said, I'm not predicting the next 25 basis points, but I think the risk for investors is that bonds go much higher. And it's a multi-decade cycle, not just the next year or the year after that. So what should investors do? Well, obviously the first obvious thing to do is don't own long duration bonds because the longer the duration, the greater interest rate risk you're taking. If you need bond exposure and you need liquidity, own shorter duration bonds. The second idea is to own banks that are asset sensitive. Banks, at least commercial banks, vanilla banks, make money by bringing in deposits and they lend those deposits out and so that spread that banks gets from deposit and lending activities is called net interest margin. You want to own banks where assets are re-pricing quicker than liabilities. As rates go up, net interest margin will expand. I own several of these banks. Some are small (e.g. Republic Bank (NASDAQ:FRBK)), some are big, but let me just use Bank of America (NYSE:BAC), a company that I have owned for several years, as an example. In every quarter in their earnings deck, they incorporate a slide that shows the net interest margin's sensitivity to changes in interest rates. If rates go up 100 basis points, Bank of America essentially makes an additional $5.3 billion in net interest margin dollars. That's the kind of sensitivity here and banks are coming off a prolonged cycle where rates have been kept artificially low, net interest margin is artificially depressed, and I think we are in the early stages of a NIM profit recovery for banks. If you look at how banks have acted over the last few days, certainly as the ten-year has moved higher, banks have done...or these spread banks, if you will, have done disproportionately well. That's number two.
Number three, investors should look at commodities - energy, materials. Public equities is probably the right way for most investors because there's material under valuation with publicly traded equities that are exposed to these areas and there's inherent liquidity with owning public equities versus owning the commodity itself. Two companies I own for clients is National-Oilwell Varco (NYSE:NOV) and Mosaic (NYSE:MOS). One metric I always look at is how sectors are currently weighted in the S&P 500 relative to historical averages - it tends to produce a really good assessment of which areas are undervalued and which areas are overvalued. Just to give you an example, materials, their S&P weighting is less than 3% today and during the last big inflationary period that ended in the early 1980s, materials were weighted well in the double digits, 13%-14%. Energy, under 7% today. Generally it's in the double digits, generally double this level; and during that last period of rising inflation, it was 27%. So I think there's a lot of room for these two sectors in particular to normalize. So that would be my third recommendation.
My fourth recommendation would be to, when you look at companies that are publicly traded and you really have to dig into this in the 10-Qs and the 10-Ks. I would stay away from companies that have floating rate debt. I mean, obviously if you have liabilities that are re-pricing based on the direction of interest rates and rates are moving higher, those liabilities are going to reprice higher. And I think there's a lot of companies that are...some companies have been good at terming out and converting floating to fixed rate debt. Those are the kinds of companies that you want to own because if we get a whiff of inflation and that has a tailwind on revenues and the cost structure will go up too, but if their financing costs stay the same, that'll expand profitability for companies. So look for fixed rate debt. That's number four.
Number five is to...and we touched on this earlier...so obviously the corollary to rates coming down and in turn that obviously had a positive impact on utilities and consumer staples is that, well, if rates are going up, these are two sectors that you want to avoid. I warned clients in my July mid-year letter to stay away from these two sectors. These two sectors have done really, really well. They're boring businesses, which is good in a lot of ways and operationally they're very stable, but investors have been paying too much for that stability. That would be my fifth recommendation.
Lastly I want to point listeners into...Warren Buffett, try to read everything you can by him. What's great is that you can retrieve a lot of things that he's published over time. In 1977, he wrote a great piece for Fortune called "How Inflation Swindles the Equity Investor."I actually went back recently and looked at this and I think listeners would be wise to read this too because the playbook for success over the next 5 or 10 years is going to look a lot different than it has over the last 5, 10, 15 or even 20 years - and with that, this concludes the November 10th, 2016 GDS Investments podcast. Thank you very much.
Disclosure: I am/we are long BAC, FRBK, NOV, MOS.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.