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?