2019 has been a fantastic year for bonds. As a matter of fact, it was the best year for bonds since 2002.
Although this asset class may deliver a small return in 2020, the risk is so much higher than the reward that it simply ain't worth it.
Overall, we still hold about two dozen of single bonds, but they are all short duration, high-paying debt, where we know the issuer and able to analyze it at all times.
Beware of maintaining your balanced/traditional allocations between stocks and bonds. Fact that 2019 has treated bonds so favorably is actually turning 2020 into a significantly less promising year.
We constantly preach for diversification. However, this is a rare case where we're doing the opposite. There's no logic seeking risk reduction (diversification) by adding more risk than reward (bonds).
One of the first subscribers of Macro Trading Factory ("MTF") has approached me a day or two after we've published the initial allocations for the Funds Macro Portfolio ("FMP"), expressing his surprise that we have very little exposure to bonds on the portfolio.
Valid question, and my answer was as follows:
First of all, the allocation is indeed not big but it certainly not meaningless. Most of the CEFs that we took on board (day 1) have exposure to bonds (and preferred shares), some with up to 50% of the allocations.
Secondly, these CEFs also come with exposures to stocks that are part of the real estate (XLRE) and utilities (XLU) sectors. Although these are equities, for good and for bad, one can't ignore the fact that most of these names are now trading as bond proxies.
Why do we say so?
Look at the past three months, and compare the total returns of all the sectors to the total return of the iShares iBoxx $ Invmt Grade Corp Bd ETF (LQD). While the latter has returned 2.35%, here are the total returns of all 11 sectors, from high to low:
Technology Select Sector SPDR® ETF (XLK): +17.26%
Health Care Select Sector SPDR® ETF (XLV): +15.16%
Communication Services Sel Sect SPDR®ETF (XLC): +12.08%
Financial Select Sector SPDR® ETF (XLF): +12.03%
Industrial Select Sector SPDR® ETF (XLI): +9.12%
Energy Select Sector SPDR® ETF (XLE): +7.18%
Materials Select Sector SPDR® ETF (XLB): +5.51%
Consumer Discret Sel Sect SPDR® ETF (XLY): +5.44%
Consumer Staples Select Sector SPDR® ETF (XLP): +4.30%
Utilities Select Sector SPDR® ETF (XLU): +2.18%
Real Estate Select Sector SPDR® (XLRE): +0.32%
In other words, what we claim is that until further notice, the allocations to (equities that are part of the) real estate and utilities sectors are almost an equivalent to an allocations to bonds. Now since most of the allocations of the Special Cases, i.e. CEFs, is to these sectors, as well as to bonds and preferred shares (PFF, PGX, FPE, PGF, PSK) - you get the picture.
Thirdly, and most importantly, we truly think that at this point in time it would be a mistake to bet big on bonds - and this is an understatement.
Although this small, initial, allocation, to bonds is only relevant for the beginning of 2020, and although we don't want/need to promise that the allocation will remain (relatively) small, it's likely that this is more an entire year view, rather a short-term, temporary, stance.
Again, nothing is (or needs to be) paved in stone, but if we have to look at 2020 (as a whole), it's likely to be tagged as a year where bonds should play very little parts in one's portfolio!
Since the last part already is a big statement, we promisedthat we would touch upon this, and explain the reasoning, in more detail. We would do so anyhow, but since this is a hot issue and certainly a very relevant one - here's the full explanation/article around it.
Although some may assume he is, "The BONE Collector" isn't a family member of neither "The Macro Teller" nor "The Fortune Teller". Who is he then? Well, the better question is what does the "BONE" stand for?
But bear in mind: His collection (of investments) changes every now and then, and so are the abbreviations he might be using to present and/or describe himself.
This can also be seen by taking a closer look at the best performers among the 100 largest ETFs.
Naturally, the hottest sector - Technology (XLK, VGT), and other growth-oriented ETFs (QQQ, VUG, IWF, IWP, VBK) are leading the pack. Only after 72 funds, we bump into the first bond ETF - iShares iBoxx $ Invmt Grade Corp Bd ETF (LQD) - that a total return of 17.4% in 2019 has granted it the 73rd place among this list.
This is a bit misleading picture for three reasons:
1. The list only takes into consideration the largest 100 ETFs. Obviously, if we expand that universe, to include smaller funds, we can find bond funds - not only ETFs - that have performed superbly.
2. LQD is an Investment-Grade ("IG") corporate bond ETF. Naturally, if we move down the credit-rating ladder it's easier to find out-performers. The better performers exist among the high-yield ("HY"; HYG, JNK, BKLN, HYLB, SHYG, SJNK, USHY, SRLN), not within the IG, segment.
3. Bonds aren't meant to outperform equities; neither in a year when the S&P 500 (SPY) is returning ~30% (including dividends), nor throughout an extended period.
Since equities come with a higher level of risk, it's only natural for the riskier asset-class to deliver better returns over time.
While most people (and articles) indeed focus on equities, we would like to dedicate this piece to bonds.
Central Banks Coming for Help
From a monetary policy perspective, no year has been more welcoming for investors than 2019 was.
No less than 67 central banks have adopted at least some sort of easing (e.g. rate cut, lower reserve ratio, asset purchases) to their monetary policies.
With only 17 central banks taking the opposite direction, i.e. tightening their monetary policies, the net number of 50 central banks that voted "easing" is unprecedented and stunning alike.
The list of central banks that elected to cut rates in 2019 is too long, but just for you to get some idea who is in (with sample cuts by the most important and/or largest-cutting ones):
- US Federeal Reserve (SPY, DIA, QQQ, IWM): -75 bps
- EZ ECB (VGK, EZU, HEDJ, FEZ, IEUR, BBEU, IEV): -10 bps
- Argentina (ARGT, AGT)
- Australia (EWA): -75 bps
- Brazil (EWZ): -200 bps
- Chile (ECH): -100 bps
- China (MCHI, FXI): -16 bps
- Denmark (EDEN): -10 bps
- Egypt (EGYP, EGPT)
- Hong Kong (EWH)
- India (PIN, INDA): -135 bps
- Indonesia (EIDO): -100 bps
- Malaysia (EWM)
- Mexico (EWW): -100 bps
- New Zealand (ENZL)
- Nigeria (NGE)
- Philippines (EPHE): -75 bps
- Russia (RSX, ERUS): -150 bps
- South Africa (EZA)
- Saudi Arabia (KSA)
- South Korea (EWY): -50 bps
- Thailand (THD): -50 bps
- Turkey (TUR): -1200 bps
- Vietnam (VNM)
On the other side of the isle, we have those central banks that decided to hike rates in 2019:
- Czech Republic (NQCZ): +25 bps
- Norway (NORW, ENOR): +75 bps
- Pakistan (PAK): +325 bps
- Sweden (EWD): +25 bps
Bonds in 2019
2019 was a superb year for bonds.
As a matter of fact, it was the best year for US bonds since 2002, with the Bloomberg Barclays Global Aggregate index total return of 8.7%.
The main factors that pushed bond returns, across the board, to such highs in 2019 were:
1. Falling interest rates and bond yields. For example:
- Federal reserve has cut if benchmark Fed Funds by 0.75%.
- 30-year US Treasury yield started the year at 3.02% and finished at 2.39%.
- 10-year US Treasury yield started the year at 2.69% and finished at 1.92%.
2. Tightening credit spreads. For example:
- US IG spreads started the year at 1.59% and finished at 1.01%
- US HY spreads started the year at 5.33% and finished at 3.60%
Interestingly, the 10-2 year US Treasury yield spread started the year at 16 bps and finished at 34 bps. Nonetheless, let's not forget that 18 bps is not that much, in absolute terms, and that 3.5 months ago this spread got inverted.
Either way, the gains during the past year have included each and every type of debt, no matter what the characteristics it comes with. No matter what is the credit rating (risky or safe), duration (long- or short- term), geographical origin (developed or emerging market), or issuer type (government, corporate, municipality) - every bond was a winner in 2019!
Having said that, there were two types of bonds that were leading the pack:
1. Long durations (the longer - the better). For example:
- PIMCO 25+ Year Zero Coupon US Trs ETF (ZROZ)
- iShares iBoxx $ Invmt Grade Corp Bd ETF (LQD)
- iShares 20+ Year Treasury Bond ETF (TLT)
- iShares TIPS Bond ETF (TIP)
- iShares 7-10 Year Treasury Bond ETF (IEF)
2. Risky issuers (the lower the credit rating - the better). For example:
- iShares JP Morgan USD Em Mkts Bd ETF (EMB)
- iShares iBoxx $ High Yield Corp Bd ETF (HYG)
- VanEck Vectors EM High Yield Bond ETF (HYEM)
- Invesco Senior Loan ETF (BKLN)
- VanEck Vectors JP Morgan EM LC Bd ETF (EMLC)
On the other hand, the combination of safety (high-grade) and short duration hasn't done that well, although even these bonds ended the year in the green:
- SPDR® Blmbg Barclays 1-3 Mth T-Bill ETF (BIL)
- Invesco Ultra Short Duration ETF (GSY)
- iShares 1-3 Year Treasury Bond ETF (SHY)
- iShares Floating Rate Bond ETF (FLOT)
- iShares 3-7 Year Treasury Bond ETF (IEI)
In spite of the strong year for equities, that was "supposed" to push bond yields up, US Treasury yields of all durations actually fell in 2019, as the Fed cut rates three times (75 bps in total) and yields on long-duration bonds (>10-year) have hit record lows.
What Can Bond Investors Expect Going Forward?
The Barclays Aggregate bond index has an annualized total return of more than 7% since its inception. Nevertheless, you can throw that number out of the window with the index now yielding just over 2%. Why so?
The single best predictor, by far, of long-term bond returns is their starting yield. Putting it differently, over time you're likely to see an average total return similar to one from which you start investing/measuring from.
Therefore, it's safe to say that bond investors must adjust their expectations from their bond holdings lower for years to come.
This also is being reflected in the Bloomberg Barclays Global Aggregate index total return (per year) above chart. As you can clearly see, during the past 40 years, the average total return per decade has moved down significantly. While in the 1980s the average total return of the index was 12.4% (!), over the past decade bond investors had to settle with a total return of only 3.7%.
This outcome is of course a direct result of what has happened to yields over the past four decades, as they moved from historical highs during the early 1980s to the current, near all-time, lows.
One doesn't need to stretch the data for too long, not even until 2002, to understand that the past year was an exception, and (more importantly) that there's very little chance for 2020 (or any year in the foreseeable future for that matter) to deliver similar returns.
Even if we look at (only) the past 12 years (2008-2019, inclusive) we already get completely different results:
- LQD 12-year average yearly return: 5.8% vs. 17.4% in 2019.
- EMB 12-year average yearly return: 6.2% vs. 15.5% in 2019.
- TLT 12-year average yearly return: 6.4% vs. 14.1% in 2019.
- HYG 12-year average yearly return: 5.6% vs. 14.1% in 2019.
- BND 12-year average yearly return: 3.6% vs. 8.8% in 2019.
- TIP 12-year average yearly return: 3.2% vs. 8.3% in 2019.
BIL 12-year average yearly return: 0.5% vs. 2.2% in 2019.
Sure thing, the exceptional performance in 2019 wasn't something unique only to bonds, and the exact same thing applies to stocks too. However, our claim is that while stocks may see another above-average year in 2020 (though not as good as 2019 was), we believe that bonds have very little chance to see anything like it, and it might be a struggle to even meet the long-term average returns.
Putting it differently, your balanced portfolio, all those with bonds accounting for 40%-60% of the total value, might be in jeopardy, without you even knowing about it.
Danger for Portfolios with >40% in Bonds
Since 2019 was a very good year for both stocks and bonds, you can only imagine that it was a very good year for balanced portfolios. I mean, it was a great year for any type of portfolio (unless you were short...), but for the sake of this discussion, we are referring to portfolios where bonds account for at least 40% of the total value. Therefore, any portfolio that's defining itself as "balanced" automatically falls into this category.
Normally, diversification is most welcome into any portfolio. By diversifying across asset classes and geographies, you avoid the need to predict the future (that's a job for Fortune Tellers) and allow yourself to focus on finding an asset allocation mix that is best suited to you.
However, sometimes diversification may become a curse, or at least a stick in the wheel - the type of "wheel" which is not made of fortune, though, this time round...
If you don't know how good/exceptional 2019 was for 60:40 (stocks:bonds) type of portfolio, try the best-ever for at least the past 20 years!
If you wish to be as accurate as possible, your 60:40 portfolio, comprised of stocks (S&P 500 index) and bonds (Barclays Aggregate index) was up 22.4% during the past calendar year, making 2019 the best year (for that type of portfolio/composition) since 1997!
Nevertheless, we all must remember that the correlation between bonds and stocks is moving back toward the flat line, slowly but surely. As such, bonds are no longer functioning as a hedge to stocks. Furthermore, the "bonds and stocks move together" - just as 2019 was - might turn out to be a double-edged (not hedge!) sword, if and when stocks reverse course.
And when we say mid 2018, we refer to the period between mid 2016, when yields where (more or less) as low as they are now, if not lower, to the end of 2018.
You may claim it wasn't so bad, but it certainly wasn't so good either...
Hard to overstate just how good it is for risky, non-energy (XLE) companies to borrow money right now. Investors basically are demanding the least yield ever to lend to these companies.
Below is the yield on the Bloomberg Barclays ex-Energy HY index:
In Europe and parts of Asia, bond sales are surging to new records. This begs the question, is it appropriate right now for central banks globally to be expanding their balance sheets? Who does this help now (if any)? After all, credit conditions aren't exactly tight, to say the least.
What can we learn from bonds about stocks?
If junk bonds are still a reliable leading indicator for equities, they seem to be signaling that more gains are waiting for stock investors ahead, particularly for small- (IWM, VB, VBR, VBK, SCZ, IWO, SCHA, VXF, IJT) and mid- (VO, IJH, MDY, IWS, VOE, VOT, SCHM, DON, IJK, IJJ, XMLV) cap stocks, which continue to underperform the S&P 500, as they did in 2019.
Yields on US HY debt already fell to a new post-2014 low, and keep falling, already looking up when they're searching for the 5% yield mark. There bonds are closing in fast on the all-time low of 4.83%.
Furthermore, US junk bonds are now yielding just about the least ever relative to the S&P 500's dividend yield.
Truth is, they don't have much to go. Not because we say so, but simply because at some point they already will trade lower than some IG debts and that would truly be something out of ordinary (although not unprecedented).
In a world where some high yields already trade/d with negative yields, "just" trading with lower yields than IG shouldn't surprise anyone, anymore.But you don't need to count on junk bonds to tell you what (we assume) you're likely wanting to hear.
US job numbers (from last Friday) underwhelmed, both on the headline number as well as on wages. Nevertheless, stocks add to their gains, and longer-term bond yields continue their slide. The message here is clear: The Fed still has the market's back, and as long as this is the situation - no other key driver should derail us from the equities train!
According to Refinitiv Lipper data, investors poured a record $8.19 billion into US corporate IG bond funds (LQD, VCIT, VCSH, IGSB, IGIB, SPSB, SPIB, VCLT, USIG, GSY) over the past week (which ended on 1/10/2020). That trounces the previous record of $6.9 billion of inflows from October 2014.
Indeed, one has to ask what such a big amount is looking for in these funds? The simple answer is that this monies - and most investors - assign zero odds for the possibility that the Fed might be tightening this year. As such, they have no fear about rising rates/yields, consequently they are not worried about losing money.
On the other hand, how much can they make on these funds even if everything goes according to (their) plan? Very little indeed.
Let us put this in a very simple intuitive way:
If everything goes according to their plan - equities will outperform bonds this year, big time.
If things don't go exactly as they plan - they may find themselves with bigger losses than stock investors. How come? Because a 25-50 bps hike/s may not do so much damage to stocks as much as they can do to bonds.
And if that sounds familiar to you - you're damn right! This is more or less what we've seen between 10/01/2016 (before the US elections) to 10/01/2018 (just before liquidity has vanished from the markets)
Holding something that underperformed no matter what doesn't sounds like a great deal to us. For that reason we're not bond collectors at this point in time.
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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.