FREE NEWSLETTER

Unpleasant Surprise

Adam M. Grossman  |  March 29, 2020

BERKSHIRE HATHAWAY Chairman Warren Buffett, in his most recent annual report, described an event that occurred at a Berkshire subsidiary last year. Late one night, a fire spilled over from a neighboring business, resulting in significant damage to the Berkshire facility, forcing it to shut down.

Fortunately, no one was injured and, as Buffett notes, the losses will be covered by insurance. Problem is, one of the company’s largest insurers was, as Buffett put it, “a company owned by . . . uh, Berkshire.” The lesson: Even the most well-managed enterprise—and a company in the insurance business itself—can find itself the victim of unintended consequences.

In recent weeks, I’ve been thinking a lot about this story. While we all understand the importance of diversification to manage risk, sometimes things go wrong in unexpected ways. Indeed, I’d argue the most unexpected aspect of this year’s turbulent financial markets is what’s happened to bonds. Traditionally, stocks and bonds have exhibited negative correlation, meaning that when one goes down, the other goes up. That’s what makes them such a powerful combination in a portfolio.

But this year, when stocks went down, most bonds went down with them. It was like finding a hole in a life raft. While this has since started to reverse, I think it’s worth pausing to understand what happened, why it happened and what lessons we can learn.

What happened? Let’s go back to Feb. 20, when stocks started to falter. At first, bonds were behaving in character, rising as stocks fell. In fact, for the first few weeks—between Feb. 20 and March 6—the bond market rose, just as expected. But then, over the following week, as the stock market’s losses deepened, the bond market started to decline, too. In all, the bond market lost nearly 9% in just that one week.

Certain areas of the bond market fared especially poorly. Between Feb. 19 and March 19, short-term corporate bonds lost 12% and high-yield “junk” bonds lost 19%. Even municipal bonds lost 16%. This was probably the biggest surprise. During this period, the only winners were U.S. Treasury bonds, with short-term Treasurys up around 2%.

Why did this happen? A number of factors came together at once. The first two are typical of any stock market downturn, while Nos. 3 and 4 are peculiar to this year’s situation:

  • Liquidity needs. Even in normal times, there’s some number of people who need to withdraw cash from their portfolios. These include retirees and university endowments, among others. When the stock market started to drop, these investors did the rational thing and sold their bonds instead of stocks, putting downward pressure on bond prices.
  • Margin calls. One of the ways brokerage firms make money is to let investors borrow against their portfolios. When the market is going up, this may seem like a good idea. But when the market turns south, some of these investors receive a dreaded “margin call.” This is a demand from their broker to pay down their loan. Faced with this problem when the stock market is down, investors normally opt to sell bonds instead of stocks. This, too, contributed to selling pressure on bonds.
  • Fear—some justified, some not. When broad-based quarantines went into effect this month, many bondholders began to worry about the impact on companies and municipalities. This also contributed to the bond market’s selling pressure.
  • Tax law changes. The 2017 Tax Cuts and Jobs Act had the effect of raising taxes for many people, especially high-income individuals in states with high state and local taxes. The result was to drive many of these folks into the municipal bond market, where they could earn income free of federal taxes. As a result, many municipal bond funds swelled in size over the past few years. That was fine until the aforementioned fears arose. That caused an unprecedented stampede out of bond mutual funds, forcing bond fund managers to unload their holdings at any price. The selling pressure was literally off the charts, as shown in figure No. 2 of this report.

While it’s difficult to quantify the relative contribution of each factor, it was the combination that caused the bond market to seize up in ways that, according to one analyst, hadn’t been seen in 40 years. Fortunately, the Federal Reserve, using its ability to effectively print money, has since stepped in. That has led to a significant, though not complete, recovery in most areas of the bond market.

What can we learn from this? I see three useful lessons. First, there’s nothing wrong with a belt and suspenders. I often talk about the danger of recency bias, which is our natural tendency to extrapolate from recent events. It’s dangerous because, until this year, the stock market had gone up nearly every year for 11 years.

The result was that many people got lulled into a false sense of security. This year’s market turmoil is a good reminder that it’s okay to build a little paranoia into your portfolio. That might take the form of a money market fund or short-term Treasury bills. There’s no science to this, except to be cognizant that risks exist in categories that we may not be aware of.

Second, remain diversified, even when it feels unprofitable. Another truism about investing is that every crisis teaches us something new—usually the hard way. In this case, it was that unique combination of four factors—two old and two new—that caused the bond market to come unglued. Next time, it will be something else.

All this is a reminder that our best and only protection is broad diversification. One investor asked last week whether he should move his entire portfolio into Treasurys, since those are what have held up best this year. It was a good instinct. After all, in finance textbooks they characterize government bonds as a “riskless” asset.

But my response was that nothing is guaranteed—not even Treasury bonds. In fact, you may recall the government shutdown in 2011 that caused U.S. government debt to be downgraded. Do I still feel very comfortable with Treasury bonds? Yes, absolutely. They’ve certainly been star performers this time around, but that may not always be the case.

The third and final lesson: Measure twice, cut once. If there’s one company that suddenly everyone knows, it’s Zoom, the videoconferencing company. It’s a great product and the stock (ticker symbol ZM) has enjoyed strong gains this year, up 123%.

But there’s another Zoom that has done even better. It’s an obscure Chinese company with no revenue that happens to be listed on the U.S. market and with a much better ticker symbol: ZOOM. As a result, this other Zoom’s stock, which in the past typically traded for about a penny a share, has shot up nearly 900% this year. The lesson: If you’re making changes to your portfolio in this environment, go slowly and be careful when making decisions under stress.

Adam M. Grossman’s previous articles include Keeping BusyHarder Than It Looks and Manic Meets Math. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our weekly newsletter? Sign up now.

Subscribe
Notify of
6 Comments
Inline Feedbacks
View all comments
Brian C.
Brian C.
1 year ago

Very helpful post Adam, Thank you. Was a bit surprised when our Vanguard Intermediate California bond fund had a decent drop. These are part of our 5th year fixed income bucket as we near retirement. Had contemplated moving it to treasury money market but decided to just stay put.

Betsy Larey
Betsy Larey
1 year ago

Adam may I ask a question? I hold 4 years of cash and dividends and the rest in stocks. I’m 65 with ( used to be 3M)and I withdraw 5% a year. I’ve always held the tried and true blue chip stocks with about 10% in small cap stocks. No funds. Only FANG I have is alphabet. I assumed the high fliers would be the first to tank They were not. But my blue chips sure did. I just can’t stomach paying 85 times earnings for something. But if they can withstand this kind of a hit, should I be thinking about adding some? Thanks!

R Quinn
R Quinn
1 year ago

Thank you for this article. It explained a lot that had me confused. In the last week I was glad to see my (municipal) bond funds once again seem to be doing their market offset job.

james mcglynn
james mcglynn
1 year ago

Looks like investors were using bond funds as money market funds for the extra yield. Fed steps in to backstop Investment Grade Bonds and should profit from that.

David Powell
David Powell
1 year ago
Langston Holland
Langston Holland
1 year ago

Extremely helpful Adam, thank you. 🙂 Given that interest rates dropped, the dive in the bond market had me wondering if the institutional guys were up to something nefarious. I had a hard time believing that individual investors were freaking out about bonds – stocks sure, but selling bonds? En masse?

Whatever the case, it is interesting comparing the slow motion crash of 2008 with 2020, relatively speaking.

The economics of this thing will unfortunately catch up, but it’s fascinating (as in terror) to see a market crash driven entirely by emotion from a non-economic source at the speed of electronic trading and information distribution. Talk about efficient markets! The securities markets have evolved into kind of a sentient global entity. That’s fine when we all disagree a bit on valuations, but when the largest players all agree all at once, it gets scary. It’s a good thing ’87 gave us circuit breakers.

Free Newsletter

SHARE