Quarterly Investment Commentary: Bonds Bubbling Over?
Quarterly Investment Commentary: Bonds Bubbling Over?
The stock market continued its impressive advance in the first quarter, with the Dow Jones Industrial Average climbing 428.58 points, or 4.1%. The broader Standard & Poor’s 500 rose 4.9%, though it remains 25% below the all-time high of October 2007. This marked the fourth consecutive positive quarter for stocks and was the best first-quarter performance since 1999. Corporate earnings came in stronger than expected, the industrial sector continued its gradual recovery, consumer spending revived modestly, and a broad spectrum of indicators painted a picture of a gradual broad-based recovery of the U.S. economy.
While personal balance sheets remain overly leveraged, corporate balance sheets are in solid shape. Undistributed corporate cash in the fourth quarter hit an all-time high of $527 billion, while the non-financial companies in the S&P 500 have a record $830 billion of cash on their books. There is evidence some of this cash may start flowing back to investors in the form of higher dividend payouts. The cash could also be utilized for mergers and acquisitions, a potential catalyst for higher share prices.
Despite all the good news with the markets and economy, individual investors remain exceedingly wary of the stock market. Mutual fund inflows in the first quarter were directed overwhelmingly to bond funds, continuing the trend from last year.
In the U.S., mutual funds took in $377 billion in 2009. Nearly all of it – some $357 billion – flowed into bond funds. U.S. stock funds, by comparison, had net outflows of 25.7 billion last year. These statistics give proof to the old adage that “bull markets climb a wall of worry” - investors must be very worried to add so disproportionately to bond funds.
“Double, double toil and trouble….”
“….Fire burn, and caldron bubble.” – chant the three witches of Macbeth as they brew up a stew of misery for the King. One can’t help but wonder if investors, in their frenzied flight to safety, may eventually get burned for their shortsightedness. Are they sowing the seeds of yet another bubble? Will they be rewarded for their prudence or is there potentially trouble in their myopic obsession. It’s common knowledge that bonds are safer than stocks, so how can they lose?
Bonds, which this author strongly endorses for their ability to mitigate market downturns and provide the proverbial anchor to windward in times of upheaval, have one critical distinction that bond funds lack – a due date. There is always the risk with individual bonds of locking down a rate that later, in hindsight, may cause regret. One can always take solace, however, in the certainty that when the bond matures you still get your principal back. A properly laddered portfolio of individual bonds buffers the investor from rising rates. Bond funds can make no such assurance and can, in fact, suffer significant price declines if rates rise rapidly. It is doubtful the hoards of investors dumping money into bond funds are aware of this fact. It has been such a long time since rates have gone up meaningfully that these seekers of stability and safety may be in for a very rude awakening.
10 Year Treasury Yield: 1881 to Present
“Fair is foul, and foul is fair.” – Macbeth, Act 1, Scene 1
Bond fund investors may some day come to feel this way about bond funds, should rates rise dramatically. How bad can it get? Consider the above chart which shows that rates have been declining in a bouncing ball fashion for nearly three decades! It is difficult for most investors to envision an environment where rates are persistently rising, but the possibility of such an event – though remote – certainly exists.
Given the imposing size of both the trade and budget deficits, there are reasons to be cautious. “How bad can it get?” one might ask. That is a difficult question to answer because so very few bond funds existed when the last meaningful run-up in interest rates occurred, but the example shown above is one of the few. This long-term, high quality no-load bond fund was started in 1971, and its chart paints a disturbing picture of what can happen when rates rise dramatically. The fund made a peak of nearly $9 per share in late 1977 and then slid steadily as rates spiraled upward. The price trough of just under $6 share coincided exactly with the peak in rates, resulting in large losses for any panicked fund investors who bailed out under the duress. The fund's share price has never fully recovered despite rates subsequently dropping, in part because in the panicked selling frenzy that ensued fund managers were forced to sell at unduly depressed prices as shareholders liquidated.
There are a number of reasons that a dramatic rate spiral like the late 70s and early 80s is unlikely, but rates need not increase that dramatically to frighten investors with nerves that are understandably still frazzled. It is probable that many believe the bond funds they hold have stability and safety comparable to a bank CD. Like tech stocks and real estate previously, the masses seem convinced bond funds are the place to be. Should the masses decide that “foul is fair” and that equities are a better vehicle for long-term growth, the ensuing shift in funds could provide significant fuel to this already impressive recovery in stock prices.
Paul Vermilya
Compass Investment Advisers LLC