Multi-Unit Franchisee Magazine Issue III, 2014 | Page 80
InvestmentInsights BY CAROL M. SCHLEIF
End of the Bond Bull?
How to manage as it looms
F
or the past 30 years, the U.S. has
experienced the longest bull market
on record for fixed-income securities. As interest rates declined,
investors in bonds benefited. Fixed-income
returns have been far above historical norms,
even outperforming stocks during crucial
periods, and investors have poured billions
into them. The seemingly inevitable end
of this run has many investors uncertain
about the future.
There has been a great deal of debate
recently regarding the notion that interest rates, which are hovering near all-time
lows, may be set to increase, particularly as
a result of the massive amounts of stimulus
provided by central banks worldwide in
the wake of the 2008 financial crisis. What
about the Fed’s balance sheet? What will
the impact be if quantitative easing continues? What are the ripple effects that may
be caused if investors create a disorderly
exit? Given the complexity of the issues,
we can touch only on a few points here.
Debt in the U.S. has risen sharply in the
past 30 years: total credit market instruments now amount to more than 3.5 times
the size of the U.S. economy as measured
by GDP. At first, it happened gradually.
In the wake of the Great Depression and
WWII, several generations of Americans
had an ingrained aversion to debt. Then
laws changed, and “debt” became “credit”
and credit became easier to obtain. For
a while the tax code favored debt and
spending over savings or investment. But
the real upswing in appetite came when
Wall Street figured out how to spread the
potential credit risk by packaging pools
of debt (mortgages and auto, credit card,
and student loan receivables). Aging Baby
Boomers liked these pooled vehicles because
they often provided high yields.
Throughout this period, inflation was
coming down and so were bond yields. Investors were also attracted to fixed-income
investments, especially in the wake of volatile stock markets. At the end of 2012, more
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MULTI-UNIT FRANCHISEE IS S UE III, 2014
than $1 trillion was invested in bond funds.
With rates near zero and the Fed working
to get a moderate amount of inflation back
into the system, many are asking, “When
does the bull end?”
As with so many investment topics,
the answear is more nuanced than most
pundits spell out. First, inflation and bond
yields don’t mean the same thing. In the
wake of the 2008 financial crisis, the Fed
and other global central banks flooded the
world market with liquidity. The pundits
feared that such great quantities of stimulus would automatically lead to inflation.
But inflation is a product not only of the
quantity of funds in the global system, but
more important, of how rapidly those funds
move in the system (velocity). Pumping
funds into a system that end up sitting on
balance sheets or in bank accounts rather
than being spent doesn’t do much to push
inflation upward. Nor, incidentally, does
it propel GDP robustly… as we’ve seen
throughout the nearly 6 years of postmeltdown “recovery.”
Interest rates, on the other hand, can
be influenced by a variety of things, including collective expectations of where
inflation might be in the future. Rates at
the short end of the yield curve have been
artificially depressed for years by the Fed’s
monetary policy. More recently, the Fed’s
quantitative easing program has worked to
keep longer-term interest rates lower than
fundamentals would have necessarily predicted. Finally, when investors get fearful
over things like unruly stock markets or
geopolitical tensions, they still knee-jerk
jump into fixed income, which pushes yields
down (not because inflation dropped, but
because demand for the bonds increased).
This artificially low interest rate environment has caused investors to go on a
global search for yield. In the process, many
have discounted potential risk in the assets
they are buying. Risk and return are always
related, but there are times when potential
risk is underappreciated. There are times
when investors are oversensitive as well
(stock market lows in 2003 and 2009). Investors in fixed income should be careful to
stick to long-term investment basics as they
search for suitable investments. Here are a
few suggestions to start the thought process:
• Get your head wrapped around the
fact that there’s no silver bullet. If something’s carrying a higher yield, there’s risk
(credit, liquidity, volatility) in it somewhere.
• Choose individual bonds over bond
funds for principal protection (presuming
high-credit quality of the underlying issuer).
• Ladder bond maturities to prevent
overexposure to a particular time frame.
• Keep durations shorter—and remember that the Fed is intervening along
the entire curve. When it stops and rates
snap up, it happens with more force at the
longer ends.
• Be willing to realize losses and swap
bonds if rates do start to rise, especially if
you can use the loss to offset gains elsewhere.
• Understand that fixed income still
has a purpose in many portfolios despite
low historic yields.
• Munis, especially for those in high
tax brackets or from high-tax states, can
be interesting.
• Look to floating rates, bank loans,
and other variable rate instruments (understanding the extra risk involved; these
are not money market substitutes).
• Consider high-quality, dividend-paying
stocks. They can generate a stream of revenue that keeps up with inflation as many
companies raise their dividends above the
rate of inflation each year.
These are just a few points on how an
investor should review the possibility of the
end of fixed-income investments. For more
detail on this, read my white paper, End of
the Bond Bull, located on the Insights page
of www.abbotdowning.com.
Carol M. Schleif, CFA, is
regional chief investment officer at Abbot Downing, a
Wells