The Bonds To Ensure Your Portfolio Survival

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Includes: BWX, DIA, DXJ, EDV, EMB, EWG, EWJ, EWU, EZU, HYG, IEF, IVV, JNK, LQD, PCY, QQQ, SPY, TLH, TLT, VOO
by: Eric Parnell, CFA
Summary

Retirement investors are facing a quandary: how to generate consistent income while protecting against portfolio downside?

Rumors are not reality when it comes to the bond market and inflation.

What the rest of the world seems to know that, the U.S. does not.

Retirement investors are facing a quandary. They want to generate a steady stream of income to support their spending needs. But both stocks and bonds that they would use to produce this income are historically overvalued, thus putting the value of the underlying principle at risk. And while some might subscribe to the philosophy of holding long enough to recover your principle value, some in retirement simply do not have this time horizon luxury. What is the retirement investor to do?

We’ve all heard the rumors about the bond bull market and inflation

“The bond bull market is over.”

“Inflation is coming.”

This has caused many retirement investors to question whether they can justify continuing to hold bonds in their portfolios. Perhaps stocks are the safer bet? After all, they, unlike bonds, can at least keep up with the rate of inflation as long as the economy is still growing. Perhaps now is the time to eschew bonds in favor of equities?

Rumors are not reality. First things first. I’ve been hearing that the bond bull market is over for more than a decade now. Yet, here we are in 2018 and the bond bull market is still intact. Have yields been rising lately? Sure, but bonds are risk assets just like stocks and commodities, and they will periodically go down in value as yields rise just like any other asset class. But until we see a sustained breakout in yields, the bond bull is just as alive as its stock market equivalent.

As for inflation? I’ve been hearing about that too for nearly a decade now. Yet, here we are in 2018. And outside of some higher oil prices as of late (never mind that volatile food and oil prices are excluded from the core inflation reading), do we really have any evidence of any meaningful and sustained inflation pressures to date? The answer is an emphatic "no." It may be coming, but it’s not here yet.

Inflation, or the lack thereof, matters a lot for bonds. Consider the following examples.

Japan

It was considered a big deal when Japanese 10-year government bond yields fell below 4% back in 1993. And in the quarter of a century since, the Japanese government has thrown the entire house surrounding the kitchen sink at the deflationary pricing pressures that have gripped their economy since. They lowered interest rates to 0%. They engaged in quantitative easing long before the acronym QE became common knowledge. And they have debauched their fiat currency in almost scandalous fashion.

Despite all of these efforts, inflation remains non-existent in Japan. Outside of some recent fleeting inflation in the less than 1% range, it has remained elusive and non-existent.

Where are Japan 10-year bond yields today, roughly a quarter of a century since they fell below 4%? Pinned at 0%. This, of course, is a lot lower than the 3% Treasury yield we have here today in the U.S. Why? No inflation in Japan.

Germany

It was more recently that the 10-year government bond yield in Germany fell below 4%. Yet, the outcome has been the same.

Where are German 10-year Bund yields today since they fell below 4% more than a decade ago? At just over 0.5%. This, of course, is a lot lower than the 3% Treasury yield we have here in the U.S. Why? Other than the fact that the European Central Bank has been buying every asset in sight, very low inflation in Germany.

Back To The United States

Inflation also remains subdued in the U.S., which is bullish for bonds. It has been roughly a decade now since the 10-year U.S. Treasury yield fell below 4% for the last time in 2008. And despite repeated proclamations that the 10-year U.S. Treasury yield is set to rise again to as high as 6% or beyond, it remains mired in a battle at the 3% line. Why? Because inflationary pressures remain subdued despite the legendarily distortive efforts of U.S. fiscal and monetary policymakers over the past decade and counting.

But couldn’t inflation pressures finally ignite in the U.S.? Maybe. For example, 5-year breakeven spreads, which serve as a predictor of future inflation, have been trending higher for more than two years now.

Yet, despite all of their upside persistence powered in part by repeated financial media and analyst proclamations, inflation expectations are still no higher today than they were during the period from 2010 to 2013, when everyone and their dog thought higher inflation was coming, yet it failed to actually materialize.

The yield curve also suggests lower inflation going forward, not higher. Consider the 2/30 spread, which is the 30-year U.S. Treasury yield minus the 2-year U.S. Treasury yield. In other words, it measures the additional premium that an investor needs to be paid right now to lock up their money in a loan with the U.S. government for an additional 28 years.

Right now, the 2/30 spread is at 62 basis points. This represents a post-crisis low in a reading that is fast-tracking its way toward inversion. Investors do not demand a rapidly shrinking premium to lock up their money for an additional 28 years if they think inflation is going to be a problem in the near-term future. Instead, they are willing to lock up their money for an additional 28 years if they think disinflation and/or deflation is the more likely outcome in the more immediate future. After all, why not lock in the higher yield today, along with the potential for capital gains in the future, if you think that inflation and interest rates are going to end up going lower sooner rather than later.

The business cycle winds are at the bond investors' back. We are currently in the second-longest economic expansion in U.S. history. Maybe it will last forever, just like maybe I will live forever, but history is increasingly on the other side of the growth cycle. And the fact that the U.S. Federal Reserve is now raising interest rates assertively despite still relatively benign economic growth is not working in the favor of a continued expansion going forward. A recession will eventually strike. And recessions (barring the hyperinflationary kind, which any future recession is not shaping up to be) are bullish for bonds, which helps explain the rapidly flattening yield curve mentioned above.

The rest of the world seems to know that inflation is still missing. When comparing the 10-year U.S. Treasury yield to its developed global counterparts, it seems that the U.S. investor might not have received the memo. At present, the U.S. 10-year yield is trading at historically high premiums relative to Japan, Germany, and the U.K. at 2.92, 2.41, and 1.53 percentage points, respectively. Assuming we dismiss the past farcical notion that we do not live in a globally integrated system despite the recent nationalist political wave and that a major global economy can enter into a robust growth phase as the rest of the world is floundering, this historically wide yield disparity suggests that the U.S. market may still be assuming the onset of inflation that the rest of the world increasingly knows is simply not coming. Regardless, the fact that this historically wide yield disparity exists should keep a lid on it widening much further, as many global investors still view the U.S. as a reliable destination for safe haven capital, and if such an allocation comes with an attractive yield premium, all the better.

Bonds are attractive in ensuring retirement portfolio survival. In fact, they are an even better long-term alternative than stocks in this regard going forward. This does not mean that bonds may not continue to struggle in the near term. And this does not mean that investors should not continue to own stocks along with bonds (I own a generous helping of both at the present time).

Be selective in bonds just as you would with stocks. I don’t own the entire stock market. Instead, I am currently focused on quality individual stocks that represent particularly attractive values and offer above-average and growing income. I also don’t own the entire bond market, as I am bearish on various spread products, including investment grade corporate bonds, high yield bonds and emerging market debt (I am particularly concerned about the latter two). Instead, I favor long-term U.S. Treasuries for all of the reasons highlighted above and more. I also favor TIPS, not only because I like TIPS in virtually all market environments, but I recognize that inflationary pressures could actually manifest themselves before it’s all over, and I wish to be hedged against such an outcome.

Disclosure: This article is for information purposes only. There are risks involved with investing, including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT, TIP. 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: I am long selected individual stocks as part of a broad portfolio strategy.