Just say no to bonds

In these pages we have often defended equities against their naysayers in the great bonds vs stocks debate that seems to be currently raging. But defence is only half the job. It is time to go on the attack! Note well, dear reader, that I know very little about bonds, and I don’t want to know any more in case I have to change my views. However knowing very little about an asset class doesn’t stop bloggers from talking about it with authoriteh, especially if it is bond apologists harping on about equities. So I, Baruch, am going to give them a dose of their own medicine.

OK, so some of the stuff below is a bit tongue in cheek. But tell me if any of it is actually untrue:

1. Bonds are zero sum games. Baruch doesn’t get out of bed on an investment if he doesn’t think he can make 30%. Ex junk, about a 10-15% swing move is the best you can hope for with bonds. Bonds don’t really make you very much money; they shouldn’t. After all, the basic proposition is you lent whoever it was a certain sum of money, and they promised to pay it to you back. Except for the interest, and you can also forecast the nominal amount of that to the penny, they’re not ever going to pay you any more than that amount. The only way you can make any real bucks on a bond is after something has gone wrong, and the poor schmoe who bought it at par sells it to you and takes a loss. Then you hope it gets better again. This means that for the most part. . .

2. To make any real money off bonds you have to be levered up. Ironically, most bonds are quite illiquid, except of course for government paper. Illiquidity and leverage are amusing bed partners and when together can create incredibly spectacular blowups. This means that bonds’ susceptibility to Black Swan events is much much higher than you think. Positive Black Swan events won’t help you so much when you own bonds (see point 1), but had you owned corporate  bonds in the depths of the 2008-2009 crisis, I bet at times you felt like putting your head between your legs and kissing your little tushie goodbye. This leads us to the most amazing thing about bonds. . .

3. Bonds are considered by their owners to be the safest of investments. This point is really funny. In fact, bonds embody systemic risk. No-one ever had to bail out emerging market equity holders in the 1980s and 1990s. Oh no, it was the Argie bond holders, the Mexican bond holders, the Thai bond holders, that had to be made whole at taxpayer expense. Remember LTCM? Some say that crisis started the cycle of destabilising bubble and crisis we have repeated twice in the past 10 started there, once in 2000 with internet stocks, and once in 2008 with mortgage securities. Again, LTCM was about overleveraged debt.  It wasn’t a “sovereign equity crisis” that got us all bothered a couple of months ago. Sure, shares blow up too, oftentimes much worse than bonds. And when things go really wrong, bondholders get paid off before the shareholders. But they can still take massive haircuts in precisely the part of the portfolio where they least expect it. You tend to build redundancy into share portfolios. You expect trouble, and those with lower risk profiles, like retirees, are encouraged to stay away from shares. The danger of bonds lies in the fact they are false friends — far more often than we think, they do not act as advertised. And too many of them are bought with leverage (see point 2).

4. So given all this, we mustn’t expect too much of the people who like bonds. Reasonable but uncharitable people have concluded that bond investors must be either lazy or stupid, and this is backed up by observation. Get this: most of them don’t even do research into the bonds they buy. They can’t even be bothered to pay someone else to do it for them! Instead bond issuers pay analysts who work for organisations we are pleased to call “rating agencies” to do the research and say whether these bonds are Good or Bad. These ratings agencies almost always agree with each other. Amazingly, bond investors are happy to ignore the inherent conflicts of interest in this relationship and actually seem to believe the rating agency. They are flabbergasted and shocked when the analysts get it wrong and the “investment grade bonds” blow up on them! Rather than blaming themselves, the investors can now blame the ratings agency, who only have to lower the investment grade rating after it is finally obvious to everyone, including the issuer, that the bond is no longer investment grade. This is fine by the ratings agency, as they are protected from competition by the government, and no one can get rid of them! Ha ha ha. Imagine if someone suggested doing that with equities, with government-sanctioned, paid for research (paid for by the company issuing stock). They’d be laughed out of town. But it’s fine for bonds. Baruch is really not making this up.

5. Bonds will get us all in the end. Despite their proven perfidy, bonds are everywhere. In fact there are so many of them around that we can’t actually pay them off, and at the same time keep everyone who wants a job employed. The fact that banks could package up dodgy mortgages into bonds and sell them off to lazy and stupid bond investors (see point 4) meant that there was no limit to the amount of credit that could be extended to illiterate fruit-pickers to buy houses they couldn’t afford. Repackaging dodgy debt into bonds was the major contributory factor to the housing bubble and our subsequent economic problems, and enabled the positive feedback loop that made the bubble so very damaging. Because of bonds, we are well on our way to double-dipping. Because of bonds, we face a generation of lower growth. Bond investors, dear readers, have made sure some of you will lose your jobs. They have limited your future economic opportunities. Don’t feel the need to be nice to them.

So now bonds are priced higher and yield less than at any point I can remember outside of total, screaming crisis. A lot of of what is driving them up is real — the economic picture does look grim. The rubber band can (almost) always be wound tighter than it is, and the tightrope walker can balance for a long time. So the next few moves for bonds may still be up as well. But to Baruch it looks like a situation with an asymmetric payoff is emerging. Really, for how much longer are we all going to be mad for bonds here? And can you all fit through the doors on the way out?

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26 responses to “Just say no to bonds

  1. sorry guys but this must be the worst bond article written in past couple weeks, now who’s gonna give my 5 min back?

    • Oh please do share with us your wisdom, mighty finance guru. And thank you for compounding your wasted 5 minutes with the extra minute you needed to write and send the comment. What particular aspect of this did you disagree with?

  2. Generally your take on bonds agrees with my view. so of course you are right. Bonds are rated, priced, and sold generally without regard to industry or systemic risk. They are rated based on the current ratios and past financial behaviour of their issuers, without much or any regard to industry or system wide risk factors. There are 2 ways to make a higher return on bonds, one is the way you describer, buying troubled bonds that turn out not to be as risky as they are thought, but also buying bonds when interest rate environment is high and holding the bonds until interst rates go lower. In the current environment it seems systemic and industry risks are higher than historical average, and the interest rate environment is way below historical average level, so there is little chance of making more than the current interest yield on bonds, and a greater risk of loss. As always, if it is your money and you trust others to evaluate investment options and give you advice, you are at the tender mercy of those whose self intersts probably do not align with yours. With apologies to the honest and ethical brokers and advisers who sincerely do their best for their clients.

  3. Really funny and mostly true.
    The allure of bonds is that people dont understand tail probability.
    Probability a 99% of getting the principal back plus x% coupon combined with a 1% probability of a loss of principal is being understood by retail investors as “we get a x% coupon and this issuer cannot reasonably be expected to fail”

  4. Re point 3 above: So the fact that equity holders got wiped out and bondholders were bailed out by the government is a reason NOT to hold bonds?

    • Well that would indeed be a reason to hold bonds over shares I suppose. But only from a selfish perspective, thinking about your investment returns and those of your clients — and not the wider socio-economic or moral implications of the bailout your reckless bond-buying necessitated.

      In fact, that should be point 6!! Yes. Bond investors are not only stupid and lazy, they are selfish and immoral too!! Free riders, relying on the rest of us to bail out their ill thought out investment decisions! This is probably WHY they can be stupid and lazy, and why they haven’t died out due to natural selection. They get us all to make up their losses.

  5. Nicholas Weaver

    Bonds are NOT zero sum games. A zero sum game is like an option, where for every $1 won, there is $1 lost (until you then subtract transaction cost. And those PROVABLY destroy investor value as a result.)

    But the actual content of #1 is right: a bond held to maturity has a maximum calculatable upside (principle + interest), and the value can NEVER exceed that maximum upside during any point in the bond’s lifetime. So I’d state it as “Bonds have an absolute price ceiling”.

    Lets take a new 10 year treasury for $1000 with a 2.5% coupon.

    The maximum this $1000 treasury could ever go to is ~$1280. Period. Even if 10 year interest rates went to zero tomorrow, that’s the maximum value.

    But, excluding default risk, the minimum value after 10 years is still $1280: thats the real value in bonds: they don’t have a volatility risk when held to maturity.

    This is the actual “safety” of bonds: you ONLY need to assess the default risk with a hold-to-maturity strategy, there is no volatility risk.

    (But that’s affected by #4: bond investors MUST be stupid, because default risk IS all!)

  6. Great post. Given how low rates have gotten, I did some poking around this morning, and learned that about half of big tech has taken out interest rate swaps over the past six months or so. IBM seems to have the biggest exposure, but CSCO and HPQ have some too. AAPL and GOOG seem not to be playing that game. I’m very nervous about what will happen when rates notch up again. I know people have short memories, but this is ridonkulous.

    • Thanks Michael — that’s really interesting about the big techs. I will check it out.

  7. You make a lot of good points. Not enough to buy equities in this lifetime or next. When the stock market is not 80% HFT, please let me know. When the banks stop hiding their loan losses, please let me know. When housing stops going down, please let me know. When they start adding jobs, please let me know. When there is acceptible inflation, not deflation, please let me know. I dont trust the equity markets. I dont trust the bond market either, but at least I will get my money back what ever it is worth at maturity. Can anyone who owns CISCO at 80 bucks say that?

    • Dear Jay, I would be very happy to sell you CSCO at 80 bucks. Was that an offer? The problem is that CSCO is actually priced at like $20, and at that price I think you make more $$ in the next 5 years off CSCO than you do buying the current 10 yr at a 2.5% going to 2% yield. And don’t worry about HFT. Stuff like that is just what people come up with for excuses as to why they lost money — “it wasn’t me, mum, it was the HFT wot done it.”

  8. ” Baruch doesn’t get out of bed on an investment if he doesn’t think he can make 30%”
    By my math, the 30y Treasuries I bought in February have delivered a ytd return of 23% on a completely unlevered basis. Should yields merely revisit their post Lehman low (2.5% on 30s), I stand to make another 25% on top of what I have already made. If U.S. 30 year yields trade to Japanese levels (currently 1.60%), stand to make a capital gain of 50% from where I sit today (on tob of the 23% I have already made).

    It is amazing me to me the willingness of people to declare a bond bubble when they have the real world examples of the 1930s U.S. and Japan before you. Yes, yields can go lower, a lot lower, and they probably will. When nominal GDP growth is cruising along at 1.5%, 3.5% on 30s is great value, without leverage. If you are worried about inflation, buy a house, get a mortgage. Deflation is the risk that is harder to hedge, and in fact long duration government bonds are the only asset that will hedge you against this risk. 100% allocated to equities? Whoops, you beter get a move on over to Treasury Direct.

    So by all means stay in bed. I’ll be selling my long bonds to you (or more likely your insurer, pension fund, bank or local government) at substantially lower yields. I agree with the first commenter, this is just about the worst article on bonds I have read. Your namesake, Bernard, is doubtless rolling over in his grave.

  9. its good to read something different (& mostly true) from the daily finance blogs.

  10. Not a tight post man. Not well researched.

    Bond and equity are a capital structure question — both are referencing the same collateral (ie, a business or whatever), and both can be good or bad depending on PRICING. Clearly there *should* be a premium for owning equity. In a bankruptcy, bond holders will, should, and have recovered far more (talk to anyone who owned Bear Stearns, Wachovia, debt…or even Lehman (better to get 30 cents on the dollar than 0). Recovery makes a difference.

    Lets go through one by one:

    1) Baruch likes to make 30%. Baruch doesn’t manage, or allocate billions of dollars of capital. In an economy that grows at 3-4% a year when things are good, opportunities for 30% returns are scarce. Bonds at 5% are pretty good deals when you need to invest $20 billion dollars.

    2) Many bond investors are naturally levered (insurance co, banks, hedge funds). Smart ones are mindful of their liability structures. Dumb ones often go out of business. Otherwise, people own bonds as a store of value. A real 2-3% a year return over 20 years is a nice compounded return if you’re primary goal is capital preservation. Harder to preserve capital in equities, for obvious reasons.

    3) Not all bonds are equal. Some are safer than others. Mexico, Thai, LTCM were all risky by any objective standard. Treasuries, vanilla mortgages, blue-chip corporates have not had the same problems. Treasuries outperformed equities over past 10-years. Not a bad situation. It’s all about pricing and entry points. Good bond managers manage risk, bad bond don’t, and go out of business.

    4) I take it you’ve never seen the Corporate Credit, CRE, or residential mortgage teams of the big banks or asset managers. If you think the PIMCOs and BlackRock’s and Western Asset and Wellington’s ($2-4 trillion of actively managed bonds) of the world are doing MASSIVE amounts of very careful and smart credit work you clearly don’t know your bonds world. These guys are PRICING CREDIT and ALLOCATING CAPITAL for the economy. It’s an important function. Banks knew they were selling crap mortgages…they’re sleazy, but they generally are clued in to what they’re buying/selling.

    Equity capital has been priced too cheaply over the past 10 or 15 or 20 years (meaning too much capital was allocated to stocks and pricing was too high…note: I’m not making a market call here). Very low overall bankruptcy/default rates, and a lot of PRICE INDIFFERENT investing nonsense like ‘dollar cost averaging and stocks for the long run’ convinced people that equities over 20 or 30 or 50 years are virtually risk free. Not true. Price and entry point. Price and entry point.

    Seems what you’re really trying to express is that there is too much leverage in the system. I agree. But this argument is shallow…sounds like what someone who only reads the NYTimes and WSJ would say.

    • 1. Hey don’t be down on Baruch’s capital! He has a fair chunk, you know. And there are LOTS of opportunities in single stocks where you *think* you may make 30%, even now. Whether you do or not is another matter.
      2. Capital preservation, blah blah. MAKING money is our goal. Baruch made 2% in his Lloyds bank young savers account.
      3. True. But no-one ever said all bonds were equal. The problem with bond managers going out of business is that they sometimes take the global economy out of business with them. Look at the poor Irish last night.
      4. I know some people at Pimco. They’re nice. But I said “most” bond investors don’t do their own research. Not “all”-. And even if they DO lots of their own research, it doesn’t mean it is very good. Didn’t MS, Bear, Lehmans and ML bond dudes actually OWN large lumps of the crap they were selling? Which was why they went out of business or came close to it. Guess that was a lapse in the very careful and smart work they were doing.

      More seriously, I prefaced the piece by saying I don’t actually know very much about bonds, and I stand by that statement! Honestly what do you expect? And Baruch only does research at work.

      I guess my actual point is not about the leverage in the system, it is that bonds and debt are much more systemically dangerous things than equities, while pretending to be much safer than they really are. Leverage is not bad per se. I use it every day. Leverage *and* illiquidity? Now that’s bad — that’s bonds.

      • Fair points, but addressable:

        I understand that Baruch wants to MAKE MONEY but Baruch is one small cog in a massive economy. It’s nearly impossible to mkae 30%/yr with $10bn or $20bn undermanagement, let alone the 100s of bns that banks and insurance companies need to invest. My point is simply that 30% opportunities are for small investors (it’s great to be small!) but they are not available for everyone, and the big investors in the world are the banks/insurers/asset managers who don’t have the option to invest 100 million or less in invidividual names…Look at Buffett…even he has trouble finding opportunities to move the needle at Berkshire (hence he accepted 10-ish% returns for a huge chunk of capital at Berlington

        2. Capital preservation is a wise strategy for some people. Or at least, for chunks of portfolios. It’s not good to go bankrupt. And most 30% opportunities carry sizeable risk (regardless of h0w good the investor is). Not good if you’re saving for retirement.

        3 + 4. Agreed — bond managers going out of business is actually ok, it’s the banks that are a bigger problem. If the world was full of equities (no bonds) the same things would happen…bonds are a much bigger market because of their risk profile, thats all. Bond’s at their core are just simple ‘interest lending’ devices (financial engineering aside…that can often be very bad). As to the banks, well, most of the people had a good sense that they were selling crap. They knew since 2006 or 2007 that this stuff was toast. Wall Street tends to do a decent job on bond by bond risk. But they didn’t realize how wide the capital implications were. IE, the CDO guys didn’t understand their own banks leverage/capital positions and the tenuous financing available, and the guys who understood bank leverage/capital/financing didn’t get how bad the CDOs were (the desks were making too much money to really stop…see Chuck Prince)

        a relatively simple relationship between overall GDP growth and long term equity and bond returns. 30% gains are outliers, and while available (yes, even in size…though not in 10 or 20 billion size) ultimately market returns end up somewhere near GDP + a future growth premium. I love equity markets — its my preferred place to invest, but bonds have an important role in investing.

        I think my primary point is that there’s nothing inherently bad in bonds (or equities). But for very good structural reasons people issue bonds and not equity (equity capital tends to be more expensive…though i think investors have not charged enough for capital in genearl lately)…The same structural reas0ns are why the global bond markets are multiples larger that equity markets, and THAT very fact is why problems tend to show up in bond markets rather than equity markets. If the world only had one capital structure: equity — than when investments went bad we’d see the problems there.

        You can make a lot of money in bonds…

      • Well if equities was the only capital structure we would all be still in the middle ages. I prefer loans to bonds, myself. I like the idea of a big friendly bank involved in my business, full of good advice, along for the ride. But I realise that we wouldn’t have quite as many loans if someone hadn’t invented bonds.

        However. Pretend for a moment that equities WERE the only capital structure: I don’t pretend we wouldn’t have problems — we’d have big ones. But the fact that is, it is extremely hard to bankrupt people without the burden of debt payments. Everything would be atomised, particularised and basically diversified, for reasons you yourself state, viz it is hard to find a suffcient number of equity investments where you can throw $100m at a time in the ring. Very very few institutions would be too big to fail, because their size would mitigate their performance. The level of systemic risk would be much lower, if not non-existent.

        But bond markets. . . that’s what created the returns to scale that led to the gigantism in the financial sector of people like Citi, or JP Morgan.

        Anyway, I also realise that you are right. I can’t really fight you on any of this any more. We can’t disinvent bonds. We can’t do without them. They are partly bad, but also useful. They are like cars, which are lethal weapons if driven badly or by the Dutch, but in fact massively contribute to our lives . You can MAYBE tweak bonds and cars to make them less dangerous. With bonds, remove the tax deductibility of interest, for instance. But even that might turn out to be a disaster for growth and capital formation. My blog post was more a corrective to this anti-equities consensus I see building everywhere. After enduring too much ill-thought commentary about how shares are no good any more, I had to kick against the pricks, as the bible says. . .

  11. Hello Baruch,

    I agree with you 100% when you say that you do not know much about bonds.

  12. Ex junk, about a 10-15% swing move is the best you can hope for with bonds.

    That is actually, factually untrue. Especially this year.

    Go read Will’s reply above, since he saved me the trouble of composing something similar. Better yet, respond to it, if you can…

    Ever heard of “duration”? I am guessing not.

    • Actually AND factually at the same time? That’s really really untrue then. Maybe I should have written “Ex junk, about a 10-15% swing move is the best you can hope for with bonds. Except when you are in an unsustainable bond bubble”

      Duration is how long things go on for. Hah.

      I didn’t answer Will because he thinks I am named after BERNARD fucking Baruch for chrissake. Honestly.

      • Anyway, another reason not to respond to Will is that if he was *really* smart he would have bought Swiss Federal 2049s in february and made like 52% with a lot less risk.

      • Actually AND factually at the same time? That’s really really untrue then.

        Yes, exactly.

        Anyway, another reason not to respond to Will is that if he was *really* smart he would have bought Swiss Federal 2049s in february and made like 52% with a lot less risk.

        This utterly misses his point. He was not boasting about some trade like a child. He was saying two very simple and specific things: (a) You are wrong in particular, and (b) you are wrong in general.

        Except when you are in an unsustainable bond bubble

        A bubble? Really? Has Time magazine run a cover with “why we love our long-duration Treasuries”? Does anybody — bull, bear, or doomer — come on CNBC pumping Treasuries? Can you find any brokers trying to sell you Treasuries?

        To the best of my knowledge, not a singe one of my coworkers, friends, or family are invested in long-duration Treasury bonds. And every article I see in the financial press is along the lines of your post. Nobody is bullish on Treasuries. Everybody either thinks a recovery is imminent, or they think the federal debt is going to create a bond crash.

        So I have to wonder, what is your definition of “bubble”? Anything that goes up a lot that you do not own or understand?

        Anyway, thanks for the post. It makes me wish I owned more bonds.

  13. Not correct:

    Hoisington (google them) is VERY bullish on Treasuries. For tyhe past 25 years. And for the past 25 years he’s made about 10% annualized returns by owning 30 year Treasuries and 30 year Treasury Zero Coupons.

    Lots of risk there…that is NOT a trade for the faint of heart…

  14. Dear Nemo, you are taking this very seriously, and may be having a sense of humour failure here. It is my fault, and I apologise; Baruch was being playful.

    You are taking too literally a post wherin it is written — in the very first paragraph — “I know very little about bonds, and I don’t want to know any more in case I have to change my views”. Then I thought that if any bond investors were reading, they may need this drummed into their heads a bit more, so I added for good measure “some of the stuff below is a bit tongue in cheek”.

    So in fact I do have a (very) vague idea of what bond duration is, and I was chastened to find out that you CAN make more than 15% in long duration bonds, and I acknowledged Will was right and I was wrong by pointing out a bond trade where you could have made EVEN MORE.

    You raise an intesting point about bubbles though — your (my?) definition is actually a good one. People investing in bubbles rarely think they are doing so. Sometimes they worry about it, but rarely enough to do anything about it; when the music is playing, we have to dance. I speak as a veteran of the internet bubble. It tends to be people on the outside who say, hang on a moment, who maybe don’t understand the ins and outs of the securities concerned, but are able to see the forest for the trees.

    Myself, I actually have no idea if bonds are in a bubble: I only really know about shares, specifically tech stocks. They’re definitely not in a bubble and are in fact much maligned. I envy you your certainty! Good luck with your (I am sure) very lovely bonds.

    • I get your humor. I just get irrational when I perceive it to be directed at me.

      I envy you your certainty!

      Oh, I am not certain at all. That is kind of the whole point. As Will mentioned, hedges against deflation are not so easy to find, and long-duration Treasuries fit the bill without the need for margin (like, say, shorting equities) or expiration concerns (like, say, buying puts).

      I think it is very unclear how one would even recognize a bubble in Treasuries. The 90′s tech bubble and 00′s housing bubble were relatively easy; you just had to turn on the TV, glance at any newsstand, or talk to pretty much anybody.

      Note that I am talking about U.S. government debt. Corporate bonds are obviously in a bubble. :-)

      Anyway, thanks for taking the time for the back-and-forth.