The Bond Buyer’s Dilemma

Bloomberg just published an article titled, Bondholders Risk $2.6 Trillion Hit on Even a Modest Yield Rise.  The piece discusses the fact that even a mild increase in yields will wipe out over $2.5 trillion in value from investors’ supposedly safe asset class – bonds.

Are Bonds a Good Investment Now? 

This is a question we are constantly asked.  We are not macro forecasters.  But we do listen to those wiser than us.  In our Quick Take Investing in Stock Bubbles we quoted Warren Buffett who cites “bonds” as an existential risk for pensions, insurance funds and retirees.   As a reminder: Buffett bet against bonds in the 1970s when they yielded nearly 10%….and won.

What sparked the Bloomberg article was the recent move in 10-year Treasuries. Yields “soared” from 1.2% to 1.6%.   Is that even a thing?  Yields moving from the floor to an inch off the floor and us saying they “soared.”   The whole situation is bizarre.  CPI is at 5.4%.

What will it take for math and common sense to matter?  How hard is this?  You don’t lend money to insolvent governments and companies for a decade in return for coupons that are below inflation rates.  THAT IS MADNESS. 

Stocks with High Equity Duration

The article also brings forward a point we have tried to make forcefully: duration is a massive risk factor in equity markets.  In our Chart for the Curious Macro Aware & The Need for KCR’s Equity Duration Tool, we provided links to our various pieces on the history of inflation and equity returns.  Most importantly, that post also showed that “growth vs. value” did not capture duration risk.  Yet our tool for measuring equity duration had a terrific ability to separate winners from losers.

We have the only credible equity duration tool in existence but we shouldn’t be surprised to see the sell-side try to stumble forward and build their own.  Note: it is much harder than it looks.

The one concern that stands out to us in the short term is the chart posted below.  People are more bearish on bonds than at any time in over 20 years.  In the short term, this type of extreme sentiment can lead to reversals.  But as the evidence piles up that inflation is here to stay, the possibility that we are at an inflection point in the 40-year bull market in bonds seems more plausible than ever.

Most Pessimistic Outlook for Bonds in History of FMS

Our papers have discussed the fact that equity duration is at record highs.  Beyond levels last seen in 2000.  The major difference for most investors is that in 2000 you could buy a 10 year Treasury bond and get a 6.5% yield.  Today there is nowhere to hide. 

Some of our other research has discussed the ability of certain long/short products to help hedge what we believe is a historic risk not seen in the post-WWII era.  How many portfolios own insurance against a seismic change in yields?  From what we can tell, market-neutral products have never been less popular than they are today.   Yet the “short” side of many of the fundamentally structured products are loaded with loss-making companies trading at valuations never seen in modern history.

With short interest having fallen to the lowest levels since records began, is it possible that these products may prove to be the only safe haven in a rising rates environment?   We authored a paper in June of last year titled 60/40 Asset Allocation: Buying a Ticket on the Titanic. We believe that the research is all-the-more compelling today than it was at its point of original publication.

Are Bonds a Bad Investment? Specifically, Those Issued by Private Equity?

Our most recent piece, Debt to EBITDA Ratios: The Spiral Higher Continues, highlighted the wholly untenable nature of lending to fund LBOs.  That piece documented that yields for such endeavors were at all-time record lows despite leverage ratios being well above government specified limits.  Worse, 90% of the loans being made to fund the most-expensive buyouts in the history of private equity, lack any covenants.

In a 2019 piece, AQR’s PhDs laid out a compelling paper suggesting that investor preference for the “…return-smoothing properties of illiquid assets…” had created an investor stampede into the asset class, eliminating a significant source of return premiums observed in PE data (specifically valuation and leverage, see “Note #1” from AQR’s paper immediately below).

In fact their work observes that higher leverage (Debt to Equity) translates to higher volatility.  Since private equity routinely uses 2x to 5x the leverage of a typical public firm it seems like investors’ conclusion that the lower volatility and diversification benefits often touted by private funds is an illusion built entirely out of reporting constructs (second “Note 2” below).

Is it possible that the most crowded trade – private equity – is little more than a stampede into what is effectively the highest duration asset on earth?  The residual claim on some of the most highly leveraged, illiquid, and unprofitable firms in that businesses’ history?  What will happen if the stampede reverses this time like it did in 2008?  Where will the liquidity come from and where will it go?

NOTE 1: “We observe that PE has grown in popularity despite a decreasing expected and realized return edge over public equity counterparts. We posit that this surprising outcome reflects the illusion of the lower risk of illiquid assets or the appeal of their artificially smooth return streams. Due to the absence of mark-to-market accounting, the reported volatility and equity beta of private assets tend to be understated, unless one desmooths their returns, which may not be a clear-cut exercise. This overstates their diversification potential or naïvely measured alpha.1 Even if one expected PE to provide zero excess return over public equity, the assumption that PE was less risky, and lowly correlated to public equity, would call for an increased allocation to PE.” –AQR Capital

NOTE 2: “Equity Risk: The principles of corporate finance dictate that all else equal, companies with greater debt-to-equity (D/E) should have higher volatility and equity beta, as the required interest payment to debt holders increases the riskiness of the remaining cash flow to equity holders. Studies indicate that PE firms take on 100%–200% debt for every dollar of equity (down from the 300%–400% D/E ratios in the 1980s), whereas publicly listed firms, on average, add 50% of debt for every dollar of equity.5 This suggests PE’s equity beta is well above 1.” –AQR Capital

We have talked about the dangers we see even in investment grade bond funds due to their extraordinary exposure to rising interest rates.   We do not believe bond yields today compensate bond investors for the risks fixed income markets require them to take.

Long duration bonds look bad for bond buyers in our view.  Yet the opposite is true for the lenders.  Equity markets understandably support stocks who retire short duration debt to issue bonds with maturities far in the future at incredible bond prices.   We believe common sense indicates that, were it not for the federal reserve, the stock market would be lower and we would see interest rates rise.

As always – we believe investors should consult with a certified financial planner.  This rant in no way should be misconstrued as investment advice.

[1] Home Unimprovement: Was Nardelli’s Tenure at Home Depot a Blueprint for Failure

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