Posts filed under ‘Fixed Income (Bonds)’

Oxymoron: Shrewd Government Refis Credit Card

Credit Card - FreeImages

With the upcoming Federal Reserve policy meetings coming up this Wednesday and Thursday, investors’ eyes remain keenly focused on the actions and words of Federal Reserve Chairwoman Janet Yellen.

If you have painstakingly filled out an IRS tax return or frustratingly waited in long lines at the DMV or post office, you may not be a huge fan of government services. Investors and liquidity addicted borrowers are also irritated with the idea of the Federal Reserve pulling away the interest rate punch bowl too soon. We will find out early enough whether Yellen will hike the Fed Funds interest rate target to 0.25%, or alternatively, delay a rate increase when there are clearer signs of inflation risks.

Regardless of the Fed decision this week, with interest rates still hovering near generational lows, it is refreshing to see some facets of government making shrewd financial market decisions – for example in the area of debt maturity management. Rather than squeezing out diminishing benefits by borrowing at the shorter end of the yield curve, the U.S. Treasury has been taking advantage of these shockingly low rates by locking in longer debt maturities. As you can see from the chart below, the Treasury has increased the average maturity of its debt by more than 20% from 2010 to 2015. And they’re not done yet. The Treasury’s current plan based on the existing bond issuance trajectory will extend the average bond maturity from 70 months in 2015 to 80 months by the year 2022.

Maturity of Debt Outstanding 2015

If you were racking up large sums of credit card debt at an 18% interest rate with payments due one month from now, wouldn’t you be relieved if you were given the offer to pay back that same debt a year from now at a more palatable 2% rate? Effectively, that is exactly what the government is opportunistically taking advantage of by extending the maturity of its borrowings.

Most bears fail to acknowledge this positive trend. The typical economic bear argument goes as follows, “Once the Fed pushes interest rates higher, interest payments on government debt will balloon, and government deficits will explode.” That argument definitely holds up some validity as newly issued debt will require higher coupon payments to investors. But at a minimum, the Treasury is mitigating the blow of the sizable government debt currently outstanding by extending the average Treasury maturity (i.e., locking in low interest rates).

It is worth noting that while extending the average maturity of debt by the Treasury is great news for U.S. tax payers (i.e., smaller budget deficits because of lower interest payments), maturity extension is not so great news for bond investors worried about potentially rising interest rates. Effectively, by the Treasury extending bond maturities on the debt owed, the government is creating a larger proportion of “high octane” bonds. By referring to “high octane” bonds, I am highlighting the “duration” dynamic of bonds. All else equal, a lengthening of bond maturities, will increase a bond’s duration. Stated differently, long duration, “high octane” bonds will collapse in price if in interest rates spike higher. The government will be somewhat insulated to that scenario, but not the bond investors buying these longer maturity bonds issued by the Treasury.

All in all, you may not have the greatest opinion about the effectiveness of the IRS, DMV, and/or post office, but regardless of your government views, you should be heartened by the U.S. Treasury’s shrewd and prudent extension of the average debt maturity. Now, all you need to do is extend the maturity and lower the interest rate on your personal credit card debt.

Investment Questions Border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs) , but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

September 12, 2015 at 10:00 am Leave a comment

Digesting Stock Gains

This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (June 1, 2015). Subscribe on the right side of the page for the complete text.

Despite calls for “Sell in May, and go away,” the stock market as measured by both the Dow Jones Industrial and S&P 500 indexes grinded out a +1% gain during the month of May. For the year, the picture looks much the same…the Dow is up around +1% and the S&P 500 +2%. After gorging on gains of +30% in 2013 and +11% in 2014, it comes as no surprise to me that the S&P 500 is taking time to digest the gains. After eating any large pleasurable meal, there’s always a chance for some indigestion – just like last month. More specifically, the month of May ended as it did the previous six months…with a loss on the last trading day (-115 points). Providing some extra heartburn over the last 30 days were four separate 100+ point decline days. Realized fears of a Greek exit from the eurozone would no doubt have short-term traders reaching for some Tums antacid. Nevertheless, veteran investors understand this is par for the course, especially considering the outsized profits devoured in recent years.

The profits have been sweet, but not everyone has been at the table gobbling up the gains. And with success, always comes the skeptics, many of whom have been calling for a decline for years. This begs the question, “Are we in a stock bubble?” I think not.

Bubble Bites

Most asset bubbles are characterized by extreme investor/speculator euphoria. There are certainly small pockets of excitement percolating up in the stock market, but nothing like we experienced in the most recent burstings of the 2000 technology and 2006-07 housing bubbles. Yes, housing has steadily improved post the housing crash, but does this look like a housing bubble? (see New Home Sales chart)

Source: Dr. Ed’s Blog

Another characteristic of a typical asset bubble is rabid buying. However, when it comes to the investor fund flows into the U.S. stock market, we are seeing the exact opposite…money is getting sucked out of stocks like a Hoover vacuum cleaner. Over the last eight or so years, there has been almost -$700 billion that has hemorrhaged out of domestic equity funds – actions tend to speak louder than words (see chart below):

Source: Investment Company Institute (ICI)

The shift to Exchange Traded Funds (ETFs) offered by the likes of iShares and Vanguard doesn’t explain the exodus of cash because ETFs such as S&P 500 SPDR ETF (SPY) are suffering dramatically too. SPY has drained about -$17 billion alone over the last year and a half.

With money flooding out of these stock funds, how can stock prices move higher? Well, one short answer is that hundreds of billions of dollars in share buybacks and trillions in mergers and acquisitions activity (M&A) is contributing to the tide lifting all stock boats. Low interest rates and stimulative monetary policies by central banks around the globe are no doubt contributing to this positive trend. While the U.S. Federal Reserve has already begun reversing its loose monetary policies and has threatened to increase short-term interest rates, by any objective standard, interest rates should remain at very supportive levels relative to historical benchmarks.

Besides housing and fund flows data, there are other unbiased sentiment indicators that indicate investors have not become universally Pollyannaish. Take for example the weekly AAII Sentiment Survey, which shows 73% of investors are currently Bearish and/or Neutral – significantly higher than historical averages.

The Consumer Confidence dataset also shows that not everyone is wearing rose-colored glasses. Looking back over the last five decades, you can see the current readings are hovering around the historical averages – nowhere near the bubblicious 2000 peak (~50% below).

Source: Bespoke

Recession Reservations

Even if you’re convinced there is no imminent stock market bubble bursting, many of the same skeptics (and others) feel we’re on the verge of a recession  – I’ve been writing about many of them since 2009. You could choke on an endless number of economic indicators, but on the common sense side of the economic equation, typically rising unemployment is a good barometer for any potentially looming recession. Here’s the unemployment rate we’re looking at now (with shaded periods indicating prior recessions):

As you can see, the recent 5.4% unemployment rate is still moving on a downward, positive trajectory. By most peoples’ estimation, because this has been the slowest recovery since World War II, there is still plenty of labor slack in the market to keep hiring going.

An even better leading indicator for future recessions has been the slope of the yield curve. A yield curve plots interest rate yields of similar bonds across a range of periods (e.g., three-month bill, six-month bill, one-year bill, two-year note, five-year note, 10-year note and 30-year bond). Traditionally, as short-term interest rates move higher, this phenomenon tends to flatten the yield curve, and eventually inverts the yield curve (i.e., short-term interest rates are higher than long-term interest rates). Over the last few decades, when the yield curve became inverted, it was an excellent leading indicator of a pending recession (click here and select “Animate” to see amazing interactive yield curve graph). Fortunately for the bulls, there is no sign of an inverted yield curve – 30-year rates remain significantly higher than short-term rates (see chart below).

Stock market skeptics continue to rationalize the record high stock prices by pointing to the artificially induced Federal Reserve money printing buying binge. It is true that the buffet of gains is not sustainable at the same pace as has been experienced over the last six years. As we continue to move closer to full employment in this economic cycle, the rapid accumulated wealth will need to be digested at a more responsible rate. An unexpected Greek exit from the EU or spike in interest rates could cause a short-term stomach ache, but until many of the previously mentioned indicators reach dangerous levels, please pass the gravy.

Investment Questions Border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in SPY and other certain exchange traded funds (ETFs), but at the time of publishing, SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 1, 2015 at 12:31 pm 1 comment

Stretching the High Yield Rubber Band

Rubber Band

The 10-Year Treasury note recently pierced below the all-important psychological 2% level (1.97%), which has confounded many investors, especially if you consider these same rates were around 4% before the latest mega-financial crisis hit the globe. Some of the rate plunge can be explained by sluggish global growth, but the U.S. just logged a respectable +5.0% GDP growth quarter; corporate profits are effectively at all-time record highs; and the economy has added about 11 million private sector jobs over the last five years (unemployment rate of 10.0% has dropped to 5.6%). So what gives…why such low interest rates? Well, as I noted in a recent article (Why 0% Rates?), there is a whole host of countries with lower rates, which acts like an anchor dragging down our rates with them. Scott Grannis encapsulates this multi-decade, worldwide rate decline in the chart below:

Interest Rate Decline 25 yrs 1-15

It should come as no surprise to many that these abnormally low rates have had a massive ripple effect on other asset classes… including of course high-yield bonds (aka “junk bonds”). It doesn’t take a genius or rocket scientist to discern the effects of an ultra-low interest rate environment. Quite simply, investors are forced to hunt for yield. When a Bank of America (BAC) customer is forced into earning less than 1/10th of 1 cent for every dollar invested in a CD, you can easily understand why the smile in their CD advertisement looks more like a grimace. Rather than accept $8 in annual interest on a $10,000 investment, post-crisis investors frightened by the stock market have piled into junk bonds. If you don’t believe me, check out the analysis provided by the Financial Times (data from Dealogic) in the chart below, which shows about $1 trillion in U.S. high-yield debt issuance over the last three years. Europe has experienced an even more dramatic growth rate in junk issuance compared to the U.S.

High Yield 2014 FT

Stretching High-Yield Band

A rubber band can only stretch so far before the elasticity forces it too snap. We are getting closer to the snapping point, as more complacent investors lend money to riskier borrowers and also accept more lenient terms from issuers (e.g., cov-lite loans). Although default rates on high yield bonds remain near decade lows (1.1% through November 2014), high-yield investors keep on inching towards an ultimate day of reckoning. Thanks to a continually improving economy, Fitch Ratings is still projecting a benign default rate environment for high-yield bonds in 2015 – somewhere in the 1.5% – 2.0% range (see chart below). However, high-yield credit spreads did widen in 2014 with the help of crude oil prices getting chopped by more than -50% over the last year. Given the energy sector accounts for about 17% of the high-yield market (Barron’s), it would be natural to expect a larger number of energy company defaults to occur over the next 12-18 months, especially if crude oil prices remain depressed.

Source: Fitch Ratings

Source: Fitch Ratings

While it makes sense for you to hold a portion of your portfolio in high-yield bonds, especially for diversification purposes, don’t forget the power of mean reversion. The uncharacteristically low default rates will eventually revert towards historical averages. Stated differently, the increased risk profile of the high-yield bond market continues to stretch, so make sure you are not overly exposed to the sector because this segment will eventually snap.

Investment Questions Border

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own a range of positions, including positions in certain exchange traded funds positions (JNK, HYG), and BAC, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

January 10, 2015 at 12:05 pm 2 comments

The Only Thing to Fear is the Unknown Itself



Martin Luther King, Jr. famously stated, “The only thing we have to fear is fear itself,” but when it comes to the stock market, the only thing to fear is the “unknown.” As much as people like to say, “I saw that crisis coming,” or “I knew the bubble was going to burst,” the reality is these assertions are often embellished, overstated, and/or misplaced.

How many people saw these events coming?

  • 1987 – Black Monday
  • Iraqi War
  • Thai Baht Currency Crisis
  • Long-Term Capital Management Collapse & Bailout
  • 9/11 Terrorist Attack
  • Lehman Brothers Bankruptcy / Bear Stearns Bailout
  • Flash Crash
  • U.S. Debt Downgrade
  • Arab Spring
  • Sequestration Cuts
  • Cyprus Financial Crisis
  • Federal Reserve (QE1, QE2, QE3, Operation Twist, etc.)

Sure, there will always be a prescient few who may actually get it right and profit from their crystal balls, but to assume you are smart enough to predict these events with any consistent accuracy is likely reckless. Even for the smartest and brightest minds, uncertainty and doubt surrounding such mega-events leads to inaction or paralysis. If profiting in advance of these negative outcomes was so easy, you probably would be basking in the sun on your personal private island…and not reading this article.

Coming to grips with the existence of a never-ending series of future negative financial shocks is the price of doing business in the stock market, if you want to become a successful long-term investor. The fact of the matter is with 7 billion people living on a planet orbiting the sun at 67,000 mph, the law of large numbers tells us there will be many unpredictable events caused either by pure chance or poor human decisions. As the great financial crisis of 2008-2009 proved, there will always be populations of stupid or ignorant people who will purposely or inadvertently cause significant damage to economies around the world.

Fortunately, the power of democracy (see Spreading the Seeds of Democracy) and the benefits of capitalism have dramatically increased the standards of living for hundreds of millions of people. Despite horrific outcomes and unthinkable atrocities perpetrated throughout history, global GDP and living standards continue to positively march forward and upward. For example, consider in my limited lifespan, I have seen the introduction of VCRs, microwave ovens, mobile phones, and the internet, while experiencing amazing milestones like the eradication of smallpox, the sequencing of the human genome, and landing space exploration vehicles on Mars, among many other unimaginable achievements.

Despite amazing advancements, many investors are paralyzed into inaction out of fear of a harmful outcome. If I received a penny for every negative prediction I read or heard about over my 20+ years of investing, I would be happily retired. The stock market is never immune from adverse events, but chances are a geopolitical war in Ukraine/Iraq; accelerated Federal Reserve rate tightening; China real estate bubble; Argentinian debt default; or other current, worrisome headline is unlikely to be the cause of the next -20%+ bear market. History shows us that fear of the unknown is more rational than the fear of the known. If you can’t come to grips with fear itself, I fear your long-term results will lead to a scary retirement.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 21, 2014 at 1:13 pm 3 comments

Stocks Winning vs. Weak Competitors



This article is an excerpt from a previously released Sidoxia Capital Management complementary newsletter (June 2, 2014). Subscribe on the right side of the page for the complete text.

Winning at any sport is lot easier if you can compete without an opponent. Imagine an NBA basketball MVP LeBron James driving to the basket against no defender, or versus a weakling opponent like a 44-year-old investment manager. Under these circumstances, it would be pretty easy for James and his team, the Miami Heat, to victoriously dominate without even a trace of sweat.

Effectively, stocks have enjoyed similar domination in recent years, while steamrolling over the bond competition. To put the stock market’s winning streak into perspective, the S&P 500 index set a new all-time record high in May, with the S&P 500 advancing +2.1% to 1924 for the month, bringing the 2013-2014 total return to about +38%. Not too shabby results over 17 months, if you consider bank deposits and CDs are paying a paltry 0.0-1.0% annually, and investors are gobbling up bonds yielding a measly 2.5% (see chart below).


The point, once again, is that even if you are a skeptic or bear on the outlook for stocks, the stock market still offers the most attractive opportunities relative to other asset classes and investment options, including bonds. It’s true, the low hanging fruit in stocks has been picked, and portfolios can become too equity-heavy, but even retirees should have some exposure to equities.

As I wrote last month in Buy in May and Dance Away, why would investors voluntarily lock in inadequate yields at generational lows when the earnings yield on stocks are so much more appealing. The approximate P/E (Price-Earnings) ratio for the S&P 500 currently averages approximately +6.2% with a rising dividend yield of about +1.8% – not much lower than many bonds. Over the last five years, those investors willing to part ways with yield-less cash have voted aggressively with their wallets. Those with confidence in the equity markets have benefited massively from the approximate +200% gains garnered from the March 2009 S&P 500 index lows.

For the many who have painfully missed the mother of all stock rallies, the fallback response has been, “Well, sure the market has tripled, but it’s only because of unprecedented printing of money at the QE (Quantitative Easing) printing presses!” This argument has become increasingly difficult to defend ever since the Federal Reserve announced the initiation of the reduction in bond buying (a.k.a., “tapering”) six months ago (December 18th). Over that time period, the Dow Jones Industrial Average has increased over 800 points and the S&P 500 index has risen a healthy 8.0%.

As much as everyone would like to blame (give credit to) the Fed for the bull market, the fact is the Federal Reserve doesn’t control the world’s interest rates. Sure, the Fed has an influence on global interest rates, but countries like Japan may have something to do with their own 0.57% 10-year government bond yield. For example, the economic/political policies and demographics in play might be impacting Japan’s stock market (Nikkei), which has plummeted about -62% over the last 25 years (about 39,000 to 15,000). Almost as shocking as the lowly rates in Japan and the U.S. and Japan, are the astonishingly low interest rates in Europe. As the chart below shows, France and Germany have sub-2% 10-year government bond yields (1.76% and 1.36%, respectively) and even economic basket case countries like Italy and Spain have seen their yields pierce below the 3% level.

63Source: Dr. Ed’s Blog

Suffice it to say, yield is not only difficult to find on our shores, but it is also challenging to find winning bond returns globally.

Well if low interest rates and the Federal Reserve aren’t the only reasons for a skyrocketing stock market, then how come this juggernaut performance has such long legs? The largest reason in my mind boils down to two words…record profits. Readers of mine know I follow the basic tenet that stock prices follow earnings over the long-term. Interest rates and Fed Policy will provide headwinds and tailwinds over different timeframes, but ultimately the almighty direction of profits determines long-run stock performance. You don’t have to be a brain surgeon or rocket scientist to appreciate this correlation. Scott Grannis (Calafia Beach Pundit) has beautifully documented this relationship in the chart below.


Supporting this concept, profits help support numerous value-enhancing shareholder activities we have seen on the rise over the last five years, which include rising dividends, share buybacks, and M&A (Mergers & Acquisitions) activity. Eventually the business cycle will run its course, and during the next recession, profits and stock prices will be expected to decline. A final contributing factor to the duration of this bull market is the abysmally slow pace of this economic recovery, which if measured in job creation terms has been the slowest since World War II. Said differently, the slower a recovery develops, the longer the recovery will last. Bill McBride at Calculated Risk captured this theme in the following chart:


Despite the massive gains and new records set, skeptics abound as evidenced by the nearly -$10 billion of withdrawn money out of U.S. stock funds over the last month (most recent data).

I’ve been labeled a perma-bull by some, but over my 20+ years of investing experience I understand the importance of defensive positioning along with the benefits of shorting expensive, leveraged stocks during bear markets, like the ones in 2000-2001 and 2008-2009. When will I reverse my views and become bearish (negative) on stocks? Here are a few factors I’m tracking:

  • Inverted Yield Curve: This was a good precursor to the 2008-2009 crash, but there are no signs of this occurring yet.
  • Overheated Fund Inflows: When everyone piles into stocks, I get nervous. In the last four weeks of domestic ICI fund flow data, we have seen the opposite…about -$9.5 billion outflows from stock funds.
  • Peak Employment: When things can’t get much better is the time to become more worried. There is still plenty of room for improvement, especially if you consider the stunningly low employment participation rate.
  • Fed Tightening / Rising Bond Yields: The Fed has made it clear, it will be a while before this will occur.
  • When Housing Approaches Record Levels: Although Case-Shiller data has shown housing prices bouncing from the bottom, it’s clear that new home sales have stalled and have plenty of head room to go higher.
  • Financial Crisis: Chances of experiencing another financial crisis of a generation is slim, but many people have fresh nightmares from the 2008-2009 financial crisis. It’s not every day that a 158 year-old institution (Lehman Brothers) or 85 year-old investment bank (Bear Stearns) disappear, but if the dominoes start falling again, then I guess it’s OK to become anxious again.
  • Better Opportunities: The beauty about my practice at Sidoxia is that we can invest anywhere. So if we find more attractive opportunities in emerging market debt, convertible bonds, floating rate notes, private equity, or other asset classes, we have no allegiances and will sell stocks.

Every recession and bear market is different, and although the skies may be blue in the stock market now, clouds and gray skies are never too far away. Even with record prices, many fears remain, including the following:

  • Ukraine: There is always geopolitical instability somewhere on the globe. In the past investors were worried about Egypt, Iran, and Syria, but for now, some uncertainty has been created around Ukraine.
  • Weak GDP: Gross Domestic Product was revised lower to -1% during the first quarter, in large part due to an abnormally cold winter in many parts of the country. However, many economists are already talking about the possibility of a 3%+ rebound in the second quarter as weather improves.
  • Low Volatility: The so-called “Fear Gauge” is near record low levels (VIX index), implying a reckless complacency among investors. While this is a measure I track, it is more confined to speculative traders compared to retail investors. In other words, my grandma isn’t buying put option insurance on the Nasdaq 100 index to protect her portfolio against the ramifications of the Thailand government military coup.
  • Inflation/Deflation: Regardless of whether stocks are near a record top or bottom, financial media outlets in need of a topic can always fall back on the fear of inflation or deflation. Currently inflation remains in check. The Fed’s primary measure of inflation, the Core PCE, recently inched up +0.2% month-to-month, in line with forecasts.
  • Fed Policy: When are investors not worried about the Federal Reserve’s next step? Like inflation, we’ll be hearing about this concern until we permanently enter our grave.

In the sport of stocks and investing, winning is never easy. However, with the global trend of declining interest rates and the scarcity of yields from bonds and other safe investments (cash/money market/CDs), it should come as no surprise to anyone that the winning streak in stocks is tied to the lack of competing investment alternatives. Based on the current dynamics in the market, if LeBron James is a stock, and I’m forced to guard him as a 10-year Treasury bond, I think I’ll just throw in the towel and go to Wall Street. At least that way my long-term portfolio has a chance of winning by placing a portion of my bets on stocks over bonds.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.


DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 2, 2014 at 11:06 am Leave a comment

Confessions of a Bond Hater

Source: stock.xchng

Source: stock.xchng

Hi my name is Wade, and I’m a bond hater. Generally, the first step in addressing any type of personal problem is admitting you actually have a problem. While I am not proud of being a bond hater, I have been called many worse things during my life. But as we have learned from the George Zimmerman / Trayvon Martin case, not every situation is clear-cut, whether we are talking about social issues or bond investing. For starters, let me be clear to everyone, including all my detractors, that I do not hate all bonds. In fact, my Sidoxia clients own many types of fixed income securities. What I do hate however are low yielding, long duration bonds.

Duration…huh? Most people understand what “low yielding” means, when it comes to bonds (i.e., low interest, low coupon, low return, etc.), but when the word duration is uttered, the conversation is usually accompanied by a blank stare. The word “duration” may sound like a fancy word, but in reality it is a fairly simple concept. Essentially, high-duration bonds are those fixed income securities with the highest sensitivity to changes in interest rates, meaning these bonds will go down most in price as interest rates rise.

When it comes to equity markets, many investors understand the concept of high beta stocks, which can be used to further explain duration. There are many complicated definitions for beta, but the basic principle explains why high-beta stock prices generally go up the most during bull markets, and go down the most during bear markets. In plain terms, high beta equals high octane.

If we switch the subject back to bonds, long duration equals high octane too. Or stated differently, long duration bond prices generally go down the most during bear markets and go up the most during bull markets. For years, grasping the risk of a bond bear market caused by rising rates has been difficult for many investors to comprehend, especially after witnessing a three-decade long Federal Funds tailwind taking the rates from about 20% to about 0% (see Fed Fatigue Setting In). 

The recent interest rate spike that coincided with the Federal Reserve’s Ben Bernanke’s comments on QE3 bond purchase tapering has caught the attention of bond addicts. Nobody knows for certain whether this short-term bond price decline is the start of an extended bear market in bonds, but mathematics would dictate that there is only really one direction for interest rates to go…and that is up. It is true that rates could remain low for an indefinite period of time, but neither scenario of flat to down rates is a great outcome for bond holders.

Fixes to Fixed-Income Failings

Even though I may be a “bond hater” of low yield, high duration bonds, currently I still understand the critical importance and necessity of a fixed income portfolio for not only retirees, but also for the diversification benefits needed by a broader set of investors. So how does a bond hater reconcile investing in bonds? Easy. Rather than focusing on lower yielding, longer duration bonds, I invest more client assets in shorter duration and/or higher yielding bonds. If you harbor similar beliefs as I do, and believe there will be an upward bias to the trajectory of long-term interest rates, then there are two routes to go. Investors can either get compensated with a higher yield to counter the increased interest rate risk, and/or they can shorten duration of bond holdings to minimize capital losses.

Worth noting, there is an alternative strategy for low yielding, long duration bond lovers. In order to minimize interest rate risk, these bond lovers may accept sub-optimal yields and hold bonds to maturity. This strategy may be associated with short-term price volatility, but if the bond issuer does not default, at least the bond investor will get the full principal at maturity to help relieve the pain of meager yields.

Now that you’ve survived all this bond babbling, let me cut to the chase and explain a few ways Sidoxia is taking advantage of the recent interest rate volatility for our clients:

Floating Rate Bonds: Duration of these bonds is by definition low, or near zero, because as interest rates rise, coupons/interest payments are advantageously reset for investors at higher rates. So if interest rates jump from 2% to 3%, the investor will receive +50% higher periodic payments.

Inflation Protection Bonds: These bonds come in long and short duration flavors, but if interest rates/inflation rise higher than expected, investors will be compensated with higher periodic coupons and principal payments.

Shorter Duration: One definition of duration is the weighted average of time until a bond’s fixed cash flows are received. A way of shortening the duration of your bond portfolio is through the purchase of shorter maturity bonds (e.g., buying 3-year bonds rather than 30-year bonds).

High Yield Bonds: Investing in the high yield bond category is not limited to domestic junk bond purchases, but higher yields can also be earned by investing in international and/or emerging market bonds.

Investment Grade Corporate Bonds: Similar to high yield bonds, investment grade bonds offer the potential of capital appreciation via credit improvement. For instance, credit rating upgrades can provide gains to help offset price declines caused by rising interest rates.

Despite my bond hater status, the recent taper tantrum and interest rate spike, highlight some advantages bonds have over stocks. Even though prices declined, bonds by and large still have lower volatility than stocks; provide a steady stream of income; and provide diversification benefits.

To the extent investors have, or should have, a longer-term time horizon, I still am advocating a stock bias to client portfolios, subject to each investor’s risk tolerance. For example, an older retired couple with a conservative target allocation of 20%/80% (equity/fixed income) may consider a 25% – 30% allocation. A shift in this direction may still meet the retirees’ income needs (especially if dividend-paying stocks are incorporated), while simultaneously acknowledging the inflation and interest rate risks impacting bond positions. It’s important to realize one size doesn’t fit all.

Higher Volatility, Higher Reward

Frequent readers of Investing Caffeine have known about my bond hating tendencies for quite some time (see my 2009 article Treasury Bubble has not Burst…Yet), but the bond baby shouldn’t be thrown out with the bath water. For those investors who thought bonds were as safe as CDs, the recent -6% drop in the iShares Aggregate Bond Index (AGG) didn’t feel comfortable for most. Although I am still an enthusiastic stock cheerleader (less so as valuation multiples expand), there has been a cost for the gargantuan outperformance of stocks since March of ’09. While stocks have outperformed bonds (S&P vs. AGG) by more than +140%, equity investors have had to endure two -10% corrections and two -20% corrections (e.g.,Flash Crash, Debt Ceiling Debate, European Financial Crisis, and Sequestration/Elections). If investors want to earn higher long-term equity returns, this desire will translate into more volatility than bonds…and more Tums.

I may still be a bond hater, and the general public remains firm stock haters, but at some point in the multi-year future, I will not be surprised to hear myself say, “Hi my name is Wade, and I am addicted to bonds.” In the mean time, Sidoxia will continue to optimize its client bond portfolios for a rising interest rate environment, while also investing in attractive equity securities and ETFs. There’s nothing to hate about that.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), including floating rate bonds/loan funds, inflation-protection funds, corporate bond ETF, high-yield bond ETFs, and other bond ETFs, but at the time of publishing, SCM had no direct position in AGG or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

July 20, 2013 at 4:05 pm 2 comments

1994 Bond Repeat or 2013 Stock Defeat?


Interest rates are moving higher, bond prices are collapsing, and fear regarding a stock market plunge is palpable. Sound like a recent news headline or is this a description of a 1994 financial market story? For those with a foggy, double-decade-old memory, here is a summary of the 1994 economic environment:

  • The economy registered its 34th month of expansion and the stock market was on a record 40-month advance
  • The Federal Reserve embarked on its multi-hike, rate-tightening monetary policy
  • The 10-year Treasury note exhibited an almost 2.5% jump in yields
  • Inflation was low with a threat of rising inflation lurking in the background
  • An upward sloping yield curve encouraged speculative bond carry-trade activity (borrow short, invest long)
  • Globalization and technology sped up the pace of price volatility

Many of these listed items resemble factors experienced today, but bond losses in 1994 were much larger than the losses of 2013 – at least so far. At the time, Fortune magazine called the 1994 bond collapse the worst bond market loss in history, with losses estimated at upwards of $1.5 trillion. The rout started with what might have appeared as a harmless 0.25% increase in the Federal Funds rate (the rate that banks lend to each other) from 3% to 3.25% in February 1994. By the time 1994 came to a close, acting Federal Reserve Chairman Alan Greenspan had jacked up this main monetary tool by 2.5%.

Rising rates may have acted as the flame for bond losses, but extensive use of derivatives and leverage acted as the gasoline. For example, over-extended Eurobond positions bought on margin by famed hedge fund manager Michael Steinhardt of Steinhardt Partners lead to losses of about-30% (or approximately $1.5 billion). Renowned partner of Omega Partners, Leon Cooperman, took a similar beating. Cooperman’s $3 billion fund cratered -24% during the first half of 1994. Insurance company bond portfolios were hit hard too, as collective losses for the industry exceeded $20 billion, or more than the claims paid for Hurricane Andrew’s damage. Let’s not forget the largest casualty of this era – the public collapse of Orange County, California. Poor derivatives trades led to $1.7 billion in losses and ultimately forced the county into bankruptcy.

There are plenty of other examples, but suffice it to say, the pain felt by other bond investors was widespread as a massive number of margin calls caused a snowball of bond liquidations. The speed of the decline was intensified as bond holders began selling short and using derivatives to hedge their portfolios, accelerating price declines.

Just as the accommodative interest rate punch bowl was eventually removed by Greenspan, so too is Ben Bernanke (current Fed Chairman) threatening to do today. Even if Bernanke unleashes a cold-turkey tapering of the $85 billion per month in bond-purchases, massive losses in bond values won’t necessarily mean catastrophe for stock values. For evidence, one needs to look no further than this 1994-1995 chart of the stock market:



Volatility for stocks definitely increased in 1994 with the S&P 500 index correcting about -10% early in the year. But as you can see, by the end of the year the market was off to the races, tripling in value over the next five years. Volatility has been the norm for the current bull market rally as well. Despite the more than doubling in stock prices since early 2009, we have experienced two -20% corrections and one -10% pullback.

What’s more, the onset of potential tapering is completely consistent with core economic principles. Capitalism is built on free trading markets, not artificial intervention. Extraordinary times required extraordinary measures, but the probabilities of a massive financial Armageddon have been severely diminished. As a result, the unprecedented scale of quantitative easing (QE) will eventually become more harmful than beneficial. The moral of the story is that volatility is always a normal occurrence in the equity markets, therefore any significant stock pullback associated with potential bond tapering (or fed fund rate hikes) shouldn’t be viewed as the end of the world, nor should a temporary weakening in stock prices be viewed as the end to the bull market in stocks.

Why have stocks historically provided higher returns than bonds? The short answer is that stocks are riskier than bonds. The price for these higher long-term returns is volatility, and if investors can’t handle volatility, then they shouldn’t be investing in stocks.

If you are an investor that thinks they can time the market, you wouldn’t be wasting your time reading this article. Rather, you’d be spending time on your personal island while drinking coconut drinks with umbrellas (see Market Timing Treadmill).

Although there are some distinct similarities between the economic backdrop of 1994 and 2013, there are quite a few differences also. For starters, the economy was growing at a much healthier clip then (+4.1% GDP growth), which stoked inflationary fears in the mind of Greenspan. Moreover, unemployment was quite low (5.5% by year-end vs. 7.6% today) and the Fed did not communicate forward looking Fed policy back then.

It’s unclear if the recent 50 basis point ascent in 10-year Treasury rates was just an appetizer for what’s to come, but simple mathematics indicate there is really only one direction left for interest rates to go…higher. If history repeats itself, it will likely be bond investors choking on higher rates (not stock investors). For the sake of optimistic bond speculators, I hope Ben Bernanke knows the Heimlich maneuver. Studying history may help bond bulls avoid indigestion.

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper.

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.

June 8, 2013 at 11:14 pm Leave a comment

Older Posts

Subscribe to Blog

Meet Wade Slome, CFA, CFP®

More on Sidoxia Services


Top Financial Advisor Blogs And Bloggers – Rankings From Nerd’s Eye View |

Wade on Twitter…

Like us on Facebook

Share this blog

Bookmark and Share


Get every new post delivered to your Inbox.

Join 1,229 other followers