It's Time To Sell Which Bonds

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Includes: CWB, JNK, MBB, PFF, QQQ, SPY, TIP, TLT
by: David Cretcher

Summary

There is a growing consensus that the 30-year bond bull market is over and it is time to sell.

Wall Street has a natural bias against bonds.

Inflation drives long-term bond performance.

Bonds are not a single asset class.

It's time to sell which bonds?

I've been told by more than one person, that it's a good time to sell bonds. With interest rates rising, there appears a growing consensus that bonds are a bad investment. As the Fed raises rates to "normal levels," the price of bonds will fall and investors will lose money.

The problem with this thinking is bonds are not a single asset class. There are many types of bonds; treasuries, perpetual, zero-coupons, convertible, junk, investment-grade, etc.

So when you're told to sell bonds, the first question should be - sell which bonds?

The Wonderful World of Stocks and Bonds

Many investors see a simple world of stocks and bonds. The line of thinking commonly sold to the public is...

First, there are stocks, which are risky in the short run, and a good bet in the long run. You can lose money in the near term, but if you simply buy and hold, you will make money over time. Be patient and you will be rewarded.

Then there are bonds, which are less risky in the short run and a terrible investment in the long run. With bonds, you're just a little ahead of inflation.

If you don't believe it, just take a look at this historical chart of the market. That should settle it once and for all.

Fig 1: Historical Performance of Stocks, Bonds and Inflation

Life Before 1983

This, unfortunately, isn't the full story. This graph shows the history, but hides the truth.

If we zoom in on the graph and look only at the first 30 years, we see that the return on stocks has clearly outperformed bonds from 1926 until 1983. The line slopes on this logarithmic chart are much higher for stocks. Stocks clearly were the better bet.

Fig 2: Stocks and Bonds before 1983

Inflated Expectations

There is also a reason for the outperformance of stocks. From 1929 until 1983, inflation in the US was high. In the long run, stocks will outperform bonds in high inflation economies because the revenues and earnings of companies also inflate.

Bonds do poorly in high inflation economies because the bonds are being paid back with less valuable money. The below graph show the high inflation of the pre-1983 period and the low inflation from 1983 onward.

Fig 3: US inflation rate from 1876 to present

(Chart courtesy of Multipl.com)

Now, compare the above inflation graph figure 3 to the thin gray inflation line on figure 2 and the thick on figure 4 - do you see the distortion? It looks like there has been a lot of inflation recently and not much in the past. But the reverse is true.

Life Beyond 1983

Now when we look at the graph from 1983 onward, we see the return, or line slope, is nearly identical between bonds and stocks. Over the last 30 years, the returns of stocks and bonds have been similar. But the bonds show much less volatility. Short-term treasuries, the green line, have lagged.

Fig 4: Stocks (blue), bonds(green), and inflation(grey) from 1983

If you could go back in time, which would you have bought? The volatile stocks or the sedate bonds? I have a shelf of investment books from this period, and almost none of them have said to buy the bonds.

There are multiple reasons for this advice. But a major one is bonds may be profitable, but they're boring. It's more interesting to talk about Facebook (NASDAQ:FB) than to talk about a utility company bond or a 30-year treasury.

Brokers can't easily tell clients "buy a long treasury, get on with your life and come see me in 30 years." So there is a natural bias against selling bonds.

What's Not On The Chart

When you buy a bond, you buy an income stream composed of the interest payment, coupon, and the maturity value. According to the figure 1, government bonds returned 5.7 percent on average from 1929 until 2016.

Instead, if in September of 1981, you bought a 30-year government bond, you would have received a non-callable guaranteed 14.81 percent for the next 30 years and received your money back.

That was arguably the best investment of the century.

I wonder how many people were told to load up on 30-year government bonds in the early eighties? I can't tell you without finding a microfiche machine. But I'm going to guess there are a few skeptics telling the public to avoid these miserable bonds at all cost, because inflation was going to fifty percent and these bonds would put you on the road to ruin.

Look at the figure 3, would you want a 30-year bond based on pre-1983 inflation levels?

The point is you can't buy a bond based solely on what might happen in the future - because we don't know what will happen in the future. Nobody does. You have to invest in what could happen in the future.

You Should Never Buy Bonds

The point is individual investors are seldom told to buy bonds, or they're told to buy them as a portfolio diversifier. Bonds are just a hard sell and nobody on Wall Street wants to do it.

So there is a natural bias against them. When rates are high like the early eighties, you avoid them because future inflation will crush you, and when rates are low, you avoid them because the interest rate can't go any lower.

The Future Ain't What It Used to Be

In the future, we know roughly what will happen, the interest rate will either go up, go down, or stay flat. And the rate of inflation will go up, go down or stay flat. The stock market will also go up, go down, or stay flat.

But, unfortunately, everything we predict about the future is a speculation at worse and an educated guess at best. As we allocate our investments, we don't know if the future will look like figure 2 or figure 3 or something else. We don't know if inflation will be the low pre-eighties type or the high post-eighties type. So we must be prepared for all possible scenarios.

Is Now the Time to Sell Bonds

So, understanding this natural bias against bonds and the problems of speculating about the future, is now the time to sell your bonds? Is the current consensus right? Given we don't know, how much should we put in bonds? And to which kind of bonds should we allocate?

Sell What Type of Bond?

Often investors think of bonds as a single thing, but bonds are more varied than stocks. Here is a chart of two bonds; the 20-Year Treasury Index (NYSEARCA:TLT) and a convertible bond index (NYSEARCA:CWB). Both are bonds, but they are non-correlated. If you're told to sell bonds, which type do you sell, or do you sell both?

Fig 5: 20-year treasury bond index [TLT] vs. convertible bond index

The reason for this discrepancy in behavior is in the short run, convertible bonds act a lot like stocks.

Fig 6: Convertible bonds index vs. the S&P 500 index (NYSEARCA:SPY)

So, if you are bullish on the market, you may want more convertibles. Or, if you are worried about the market, you may prefer some convertibles instead of stocks. You will pick up some upside, and the higher dividend will give a little downside protection.

On the other hand, in the short run, treasuries act like stock market hedges. Historically, nervous investors tend to defect to treasures. Optimistic investors tend to avoid them. They were a nice addition to a portfolio in 2009.

Fig 7: 20-year Treasury [TLT] index vs. S&P 500 index

If you're bearish on the market, you may want to keep a few treasuries in your portfolio to hedge against down markets.

If you are worried about inflation, you can add some long-term TIPs; they provide protection against unexpected inflation and also some cushioning against stock market corrections.

Fig 8: Long-term TIP index (NYSEARCA:LTPZ) vs. S&P 500 index

So, if it seems like the time to avoid bonds in general (NYSEARCA:AGG), you can fine tune your portfolio with a mix of convertible bonds, treasuries [TLT], TIPs, mortgage bonds (NYSEARCA:MBB), preferred stocks(NYSEARCA:PFF), and junk bonds(NYSEARCA:JNK). They are all bonds, but each one behaves differently in different markets.

In the future, if you hear someone say, now is the time to sell bonds, ask yourself - which bonds?

Investment Implications - Trump Bump or Trump Slump?

Which bonds you want to own depends on how you feel about the future.

Trump Bump - If you're bullish on the stock market, and you believe the President's advertised "pro growth agenda" of lower marginal taxes, lower corporate taxes, decreased regulations, infrastructure spending and increased government debt will happen and be successful when it does, then you want to own bonds that do well in bull stock markets and hot running inflationary economies.

Favor bonds like convertible bonds and junk bonds [JNK]. Own more inflation sensitive bonds (NYSEARCA:TIP) and fewer Treasuries [TLT]. Bet on shorter duration bonds and shun longer durations.

Trump Slump - On the other hand, if you believe the stock market is too optimistic and the pro-growth agenda will stall in Congress, come too late, or be ineffective when it comes, then you want to own more treasuries, less inflation-sensitive bonds and fewer convertibles and junk.

Aggressive investors could consider zero-coupon treasuries. Conservative investors should look at preferreds. You should seek higher yielding, longer duration bonds. These bonds will perform well when the Fed starts to cut rates in the next economic slump.

Undecided - If you don't know what will happen, you should invest in a diversified portfolio of all bond types. Look for bonds like preferreds and cushion bonds that do well in slow growth economies.

Build your bond portfolio to perform in the future you believe is most likely. Understand what you are betting on, and that way you won't be surprised at your results.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and discussion purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. All investment and speculations have risk. I am not your investment advisor, please consult your financial and tax advisers before investing.

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