Seeking Alpha

Upside Down: The Bond/Stock Dilemma

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Includes: AGG, GLD, SPY, TLT
by: Michael A. Gayed, CFA
Summary

Recession means less economic activity, which means less borrowing, which means lower interest rates, which is good for bond investors.

For every 10 bp decline in the 10-year Treasury yield today, its price goes up by a lot more than it would have when rates were higher.

Both have the potential to be meaningfully violent in terms of performance going forward.

“I hate violence, yes I do. It's kind of a dilemma, huh?” - Jackie Chan

With equity market volatility creating all kinds of anxiety – or more accurately, reflecting the anxiety created by tweets and trends in the real economy – we’ve been hearing more about the upside/downside capture ratio of bonds vs. stocks. Divide the return on bonds by the return on stocks (put a minus sign in front of the bond returns) and that’s the ratio. If it’s close to 1.0, a decline in stocks is entirely offset by an increase in bonds – if you’re a traditional 60/40 pension fund, that’s reassuring.

Recession means less economic activity, which means less borrowing, which means lower interest rates, which is good for bond investors. Ignoring short-lived bumps in the road that cause the equity market to seize up from time to time but go largely unnoticed or ignored by the bond market, this argument has tended to hold up.

Largest declines in the S&P 500 and the 10-year Treasury return that year

Recently, bonds have been providing quite a safety net. “Obviously,” you might say – because yields have fallen (again) as investors globally turn to U.S. Treasuries that still offer a fat yield compared to the negative rates on European government bonds.

What’s news is that the upside/downside ratio of bonds (AGG) to stocks (SPY) has been larger recently than in the past. Does that mean that, for a given decline in equities, investors are throwing more money at bonds than ever before? And, assuming equity markets decline primarily in response to an increased threat of recession, does that mean investors are really concerned?

What we may be overlooking is the fact that in today’s super-low rate environment, for every 10 bp decline in the 10-year Treasury yield today, its price goes up by a lot more than it would have when rates were higher. Why? Because of Bond Math. As rates decline, duration gets longer. Really low yields (like a 10-year Treasury at 1.5%) means a really long duration – close to 9.0, so a 1/10th of a percent decline in yields means a 0.90% increase in price for the 10-year, not even including interest income. In the bear market of the early 2000s, the duration of the 10-year ranged between 7.0 - 8.0. In September 2008, the duration was just over 8.0. Now we’re pushing 9.0, and we won’t even get into convexity, which adds extra juice.

Duration of the 10-year Treasury

If the U.S. equity market heads south as we head for the fourth quarter of 2019, bonds (TLT) will have already turned in a stellar performance. The big fear, of course, is that U.S. rates will go even lower into the trap the European Central Bank is still trying to escape. Since the Great Depression, when the equity market delivered a negative return for the year, the bond market tended to offset it, at least somewhat. Basic premise: If things go badly in the equity market, bonds will ride to the rescue, at least most of the time. Whether this remains the case is the question mark. Both have the potential to be meaningful violent in terms of performance going forward.

Perhaps gold (GLD) may be a better safe haven’t asset next time around?

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 writing is for informational purposes only. It does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction. It also does not offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.