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Ditching Bonds

John Lim

THE RECENT CARNAGE in bonds has been unusually fierce. The Bloomberg Aggregate Bond Index is down more than 7% year-to-date. Unfortunately, this may be the tip of a very large iceberg. I believe we may be standing on the precipice of a multi-decade bear market for bonds.

The reason for my concern can be summed up in one word: inflation. It’s the great enemy of bond investors—and yet, despite an inflation rate that’s at four-decade highs, investors remain far too complacent.

Evidence for this can be seen in the 10-year breakeven rate—the difference in yields between the conventional 10-year Treasury note and 10-year Treasury Inflation-Protected Securities (TIPS)—which now stands at around 2.8%. That implies investors expect inflation to average just under 3% over the next decade. While that number is at multi-decade highs, it could still be too rosy.

Despite the painful bond market decline, the yield to maturity for the broad bond market isn’t much above 2%, which is deeply negative after subtracting the rate of inflation. Since pronouncing the demise of the 60% stock-40% bond portfolio, I’ve pared back my bond holdings—with the exception of inflation-linked Series I savings bonds—from nearly 15% in early January to 5.5% today, using some of the proceeds to buy more international stocks.

The four most dangerous words in investing are, “This time it’s different.” Still, I believe my bearish view on bonds is rooted in fact, not fear. Here are five reasons investors may want to rethink their long-term bond allocation:

1. Real bond yields remain deeply negative.

The inflation rate has been between 7% and 8% over the past three months, based on the Consumer Price Index. The 30-year Treasury now yields 2.67% nominal or about -5% in real terms, assuming an inflation rate of 7.5%. Sure, inflation may eventually fall back to lower levels. But it would need to recede to 2% for real yields to rise above zero. I don’t think that’s in the cards, as I’ll explain in point No. 2.

As a bond investor, there’s isn’t much guesswork when figuring out the returns you’ll likely receive. You need only look at a bond fund’s yield to maturity. Vanguard Total Bond Market Index Fund (symbol: VBTLX) has a yield to maturity of 2.3%, far below the current inflation rate. I don’t know about you, but investing in an asset with a guaranteed negative real return isn’t too compelling.

2. Resurgent inflation is a game-changer.

Over most of the past three decades, we’ve enjoyed sub-3% inflation. Those days may be over. In their recent book, The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival, economists Charles Goodhart and Manoj Pradhan argue that we will experience resurgent inflation over the coming decades.

If this is true, the Federal Reserve is in a box. It must choose between fighting inflation or preserving economic growth—it can’t do both. If the Fed goes down its current path of raising interest rates and reversing quantitative easing (QE), the economy will slow and most likely head into recession. Both rising interest rates and quantitative tightening mean lower bond prices.

On the other hand, if the Fed pivots to save the economy by lowering interest rates and resuming QE, that’ll add further fuel to the inflation fire. Higher inflation means lower—even negative—real returns for bond investors.

In short, there’s almost no way for bond investors to win. To be sure, it’s conceivable that nominal yields fall—or are driven down by the Fed—toward zero, which would push bond prices higher. But that’s like picking up pennies in front of a steamroller. The risks outweigh the rewards.

3. Bond bear markets can be brutal.

Everyone knows that bear markets in stocks can be punishing. But stock bear markets are mercifully short, averaging just under 10 months. While the bond market is far less volatile year to year, bond investors may instead suffer a death by a thousand cuts. Those cuts are inflicted by—you guessed it—inflation.

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A picture is worth a thousand words. Look at the chart titled “Inflation-Adjusted Government Bond Drawdowns: 1926-2017,” courtesy of financial blogger Ben Carlson. Long-term government bonds experienced an after-inflation 60% decline over a period lasting almost 50 years. Five-year bonds didn’t fare much better, suffering a loss of 40% over the same time frame.

4. Bond investors remain complacent about inflation.

Perhaps I’ve convinced you that the outlook for bonds is poor. But could the bad news be priced in already? After all, some of the best investments are made when the news is bleak but what’s priced in is even worse.

Unfortunately, I fear the opposite is true. As I mentioned earlier, the 10-year inflation breakeven implies investors expect roughly 3% inflation over the next decade. That’s far too sanguine.

Let’s look at bonds from the viewpoint of stocks. A bond’s price-earnings (P/E) ratio is just the inverse of its yield to maturity. Vanguard’s total bond market fund has a yield to maturity of 2.3%. That corresponds to a P/E ratio of 43.5. By comparison, at the height of the dot-com bubble in 1999, the cyclically adjusted price-earnings (CAPE) ratio for U.S. stocks was 44.2. Today, the CAPE ratio for stocks stands at 36.5.

When looking at numbers like these, some will argue that the U.S. stock market is not overpriced. Maybe, maybe not. But one thing is clear: Bonds are expensive.

5. Could Treasurys be downgraded—again?

While bonds are typically thought of as the safe portion of a portfolio, it’s worth reviewing the risk of owning bonds. There’s interest rate risk, namely the risk that bond prices will fall should interest rates rise. That risk can be quantified by a bond’s duration—the longer the duration, the larger the interest rate risk.

There’s also inflation risk, which we’ve discussed already. Finally, there’s credit risk, sometimes called default risk. U.S. Treasury bonds are considered to have negligible credit risk, as they’re backed by the full faith and credit of the U.S. government.

In 2011, Standard & Poor downgraded the credit rating for the U.S. one notch to AA+, down from its top rating of AAA. Moody’s and Fitch have maintained their highest credit rating for the U.S.

I’m not predicting another downgrade anytime soon. But the numbers are not reassuring. Total public debt as a percent of gross domestic product peaked at around 136% in 2020 and stands at 123% today. The cost to service that debt could put the Treasury in a real bind, should interest rates rise from today’s historically low levels. No one is talking about this sort of credit risk, but that doesn’t mean it doesn’t exist.

I want to be clear. I’m not suggesting that you make radical changes to your portfolio’s asset allocation. Nor do I suggest you replace your bonds with stocks. Stocks are far risker than bonds, especially in the short term.

But I do think it’s important to give greater thought to the real risks—pun intended—bonds carry in a regime of higher inflation. As I mentioned earlier, I have pared my bond allocation significantly. My largest bond holding is in a TIPS bond fund, as such funds are protected against inflation risk—though they are still subject to interest rate risk. I also plan to continue buying Series I savings bonds, though the major drawback is the $10,000 purchase limit per year.

As readers of my previous articles will know, I also have significant holdings of gold and gold mining companies. Gold has served as a store of value for many millennia and, cryptocurrencies notwithstanding, I expect it to remain so. Gold is particularly attractive when real bond yields are negative, as they are today.

John Lim is a physician and author of “How to Raise Your Child’s Financial IQ,” which is available as both a free PDF and a Kindle edition. Follow John on Twitter @JohnTLim and check out his earlier articles.

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Bo Simmons
Bo Simmons
6 months ago

John, thanks for this article! I started reading humble dollar thanks to your mention on CNBC squawk box talking about ibonds. I’m trying to digest the implications for myself and my DIY portfolio at Fidelity. At age 58 -I’m couple to few yrs from a full or mostly full planned retirement. Currently, I’m roughly 15% cash 15% bonds 70% equities in both Taxable and IRAs. I choose to favor individual bonds over bond funds expecting rates to rise at some point and wanting to be able to wait for redemptions. My question is do you have any suggestions for thinking/analysis framework where I bought longer-dated ex 2050 but highly rated A and AA bonds (Amazon, Alphabet{google}, Regeneron, Waste Management etc) and even where I bought non divestment grade like Ford but still long dated. These are onsale but I’ve bot been tempted. My main concern goes to your point about holding negative real return bonds for decades. Thoughts?

patdady
patdady
7 months ago

I’m a 70 year old who has been holding approximately 20% of my IRA in a Vanguard short term bond fund for the past several years in lieu of holding it in “cash”. I’m tired of seeing my bond value drop but my instinct is to stay the course. Any chance my short term bond fund will recover from my losses to date?

Gene Simmons
Gene Simmons
7 months ago

I have seen some commentary recently that the Fed cannot increase rates over 3.5% because at that rate the US Government becomes insolvent. But wouldn’t that only apply to new bonds issued? The vast majority of the US debt servicing would still be well below 3.5% for medium and long term bonds. So I assume rates could go well above 3.5% without causing a default. And even then, the US could avoid default by raising taxes.

Nate Allen
Nate Allen
7 months ago
Reply to  Gene Simmons

I Googled around a bit but could not find any articles to that effect. (3.5% causing insolvency)

Where did you see this commentary? I would be interested to hear the explanation, because I can’t imagine why that would be the case.

Gene Simmons
Gene Simmons
7 months ago
Reply to  Nate Allen

Who Will Buy Bonds the Fed No Longer Wants?By Marcus Ashworth and Mark Gilbert | Bloomberg
April 8, 2022 at 11:25 a.m. EDT

The rate quoted was actually 3% in that article.

The idea is that every 1% increase adds $300 billion annually to the deficit.

Again, I am also questioning that assertion, because that would assume that all the existing debt comes due at once. Some lower yielding bonds won’t mature for decades. So rates would need to rise well above 3 percent. Perhaps even 10% before this should become an immediate concern. That should give the Fed some room to increase rates substantially.

Last edited 7 months ago by Gene Simmons
betsy larey
betsy larey
7 months ago

Here’s the thing about bonds. The only way to own them is to buy individual bonds. What you get is what you get. Bond funds have a charge, which eats into your return. Why or Why would anyone own one? Keep 3 years in cash, the rest in stocks. If you need income, buy stock ( or funds) that pay a dividend

betsy larey
betsy larey
7 months ago

I sold my business in 06, and my advisor recommended 60/40. I did the opposite, put 60 in bonds. In 09, I sold the bonds and put all of it in stocks. Best move I have ever made. To this day, I have never owned bonds. 2nd best move I’ve ever made. The bonds I owned got called early, and the ones i was stuck with paid little. I think financial advisors should tell retired people to keep a bunch in cash if they are nervous. But do not invest in bonds. Ever

Curtis Holle
Curtis Holle
7 months ago

Mr. Lim reducing his bond exposure by 63% feels a little like market timing to me.

No offense but it seems Mr. Lim thinks he knows more than the market when he says the market’s 10 year inflation outlook of 2.8% is incorrect.

A person shouldn’t try to market time the equity market. Is the bond market different? Or am I missing something?

Nate Allen
Nate Allen
7 months ago
Reply to  Curtis Holle

Isn’t pretty much everything market timing in the strictest sense?

Determining how much to allocate to the S&P 500 vs Russell 2000 vs Nasdaq vs the Dow vs Europe vs China vs Emerging Markets vs …. (you get the idea) inherently shows a preference for one set of things over another moving into the future.

Percent allocation of bonds vs stocks? Again, preference is shown for the future.

Whatever one’s allocation, and whatever one is allocating for contributions inherently shows a preference for one thing over another in the future.

This is likely based on some set of things, for instance domestic US has been beating international for awhile so most people will tend to do that. A stock/bond allocation of something like 60/40 has worked for awhile so lots of people do that. However, if we go further down the rabbit hole of optimizing based on indicators, market conditions, etc. then people tend to get squeamish as this sounds more like market timing. There is always a continuum, though. Just because you chose a 60/40 portfolio with 50/50 stocks to domestic/international, doesn’t mean that isn’t a prediction about what will happen in the future based on what has happened in the past.

Curtis Holle
Curtis Holle
7 months ago
Reply to  Nate Allen

When I choose my asset allocations, I pay no attention to where others project the markets are going in the short term. My asset allocation decisions are based solely on my risk tolerance and the time horizon of my goals.

In my view, this does not meet the definition of market timing.

mytimetotravel
mytimetotravel
7 months ago
Reply to  Curtis Holle

Rebalancing is not market timing either. My asset allocation, in retirement, is 50-50, and I see nothing in this article that would be of any help in changing it. (I am certainly not going to get into gold.) I will rebalance if I am at least 3% off my allocation.

John Sorrell
John Sorrell
7 months ago

The bond market is many times the size of the stock market. If we think the latter is reasonably efficient, isn’t the former as well and all of this information already baked into current prices? Isn’t this a case of thinking you’ve got something figured out that this enormous market, with highly sophisticated investors, doesn’t?

Curtis Holle
Curtis Holle
7 months ago
Reply to  John Sorrell

I read your comment after I made my comment. I’m 100% on board with your thoughts.

Last edited 7 months ago by Curtis Holle
Nate Allen
Nate Allen
7 months ago
Reply to  John Sorrell

The bond market is many times the size of the stock market.

The bond market is definitely larger than the stock market, but certainly not “many times the size”. The size of the world bond market is around $120 trillion or so and the size of the world stock market is around $95 trillion or so. US has roughly similar proportions.

Curtis Holle
Curtis Holle
7 months ago
Reply to  Nate Allen

Point taken regarding size of the bond market.

But John’s question regarding Mr. Lim’s actions remains. “Isn’t this a case of thinking you’ve got something figured out that this enormous market, with highly sophisticated investors, doesn’t?”

David Powell
David Powell
7 months ago

I can’t believe the BoA US high yield index/Treasury spread @ only ~3.5%.

Nate Allen
Nate Allen
7 months ago

Would some of the “inverse” bond funds be safer bets? (Go the opposite direction to bonds)

Andrew Forsythe
Andrew Forsythe
7 months ago

John, thanks for an interesting and provocative article. As someone with a more typical allocation which includes a good chunk of bond funds, it certainly got my attention. The hit those funds have taken recently has been painful and has increased my concern.

Coincidentally, today I also received a link to the current article written by Kathy Jones, Schwab’s Chief Fixed Income Strategist: At Last—Income in the Fixed Income Market | Charles Schwab She doesn’t seem nearly as pessimistic about the prospects for bonds going forward.

I am very much an amateur DIY investor and don’t pretend to understand all the data or theory in either your article or Kathy’s. Which leaves me with a bit of a dilemma. My instinct is to stay the course, but maybe with a little trimming around the edges. Your article, in fact, cautions not to make radical changes. Maybe if my online savings accounts finally start paying a decent rate of interest, I might shift a little money in that direction.

Thanks again for another of your well written articles—I always enjoy them.

johntlim
johntlim
7 months ago

Andrew, thank you for your kind remarks. I am in the same boat as you are, being an amateur DIY investor. I think your instinct to stay the course is correct. I’ve heard it said that the best asset allocation is the one you can stick to. I believe there is great wisdom to that.

No one has a crystal ball. I could be 100% wrong about inflation, and if I am, I’ll write a follow-up piece about it. I hold my convictions lightly. That said, the Federal Reserve is also not omniscient. The bottom line is that the economy and markets are incredibly complex and ambiguous, which is partly why they are so fascinating to me.

James McGlynn CFA RICP®
James McGlynn CFA RICP®
7 months ago

The unwind from the Federal Reserve’s Quantitative Easing is being felt acutely in the Treasury and mortgage market. When I refinanced less than a year ago I locked in 2.375% for a 15 year mortgage. I am borrowing for 15 years at rates cheaper than the Treasury is paying for 2 years currently. Those of us in our 60’s remember the high interest rates whereas the younger generation assumes bond funds are safe since they haven’t ever seen interest rates increase. I prefer money market funds, I-bonds and 1 year Tbills. For more ballast I have cash value in life insurance that would benefit from rising rates.

Bruce Edwards
Bruce Edwards
7 months ago

Hi John, thanks for the insight on bonds and some alternatives. Question on the gold holdings? Do you suggest owning them in pre or post tax accounts if you have a choice?

thanks

johntlim
johntlim
7 months ago
Reply to  Bruce Edwards

I would generally avoid holding ETFs backed by gold directly (such as GLD) in taxable accounts, as they are treated as “collectibles” by the IRS with maximum long-term capital gains rates of 28% (rather than 20%).

As for indexed ETFs of gold mining companies (such as GDX), the dividend yield is less than 1% so “tax drag” is not a major consideration. I’ve held GDX in taxable, tax-deferred, and tax-free accounts.

Hope that helps, Bruce.

isrosenberg
isrosenberg
7 months ago

John – thanks for the excellent write-up on bonds and the inherent capital risk in a rising rate environment. The question I have, for which I can’t seem to reach a conclusion is whether, going forward, if interest rates continue to climb will bond fund prices continue to decline or are anticipated/expected rate increases already reflected in the current prices?

The reason I ask is that for short term assets held in short and ultra short term investment grade bond funds, for which the YTD total return has been -4.2% and -1.1% respectively, I can accept the -1% total return but not -4% total return for these assets and prefer to limit interest rate risk going forward. With a duration of 2.75 years and 0.98 years, respectively, what is the expected timeframe, if any, for these funds to “break-even”.

The consensus from my research suggests that high-yield savings accounts, Series I Savings bonds and TIP bond funds may be more suitable for short-term use assets (1-2 years).

Your perspective is appreciated.

Last edited 7 months ago by isrosenberg
johntlim
johntlim
7 months ago
Reply to  isrosenberg

The best measure of interest rate risk is duration. If a bond fund has a duration of 2.75%, for example, and interest rates rise by 2%, the bond will decline in value approximately 5.5% (2.75 x 2). So, you are “safer” in the short run in low duration bonds from the perspective of capital losses (interest rate risk). But, over the longer term, inflation could destroy your real return, even if your capital losses are small. That is why inflation is the real threat to bond investors.

wtfwjtd
wtfwjtd
7 months ago

Nice write-up John. I’m also of the mind that this time really *is* different, when you consider the artificial suppression of long rates that we’ve experienced over the last several years. With the Federal Reserve buying up huge chunks of long debt in the form of US Treasuries, the risk premium for holding long bonds has pretty much evaporated, and greatly reduced the significance of the yield curve as an analytical tool. We may soon find out how this sort of manipulation ends, but right now it don’t look too pretty. And I never thought I’d say it, but the 0% real return of the I-bond actually looks downright appealing after a look at that long chart in Ben Carlson’s article. Wow, what an eye-opener.

johntlim
johntlim
7 months ago
Reply to  wtfwjtd

I’ll be the first to admit that long-term predictions are basically worthless. But if the new normal for inflation is closer to 4 or 5%, the outlook for bonds is pretty bleak. As Howard Marks likes to say, you can’t predict but you can prepare. The one no-brainer investment today to prepare for higher inflation is I-bonds. If there is one silver lining to the ugly inflation prints of late it’s that awareness of I-bonds is beginning to spread…

PAUL ADLER
PAUL ADLER
7 months ago

What is one to do if 25% of their portfolio is in 6 year duration bond funds and is currently drawing down their portfolio in retirement?

johntlim
johntlim
7 months ago
Reply to  PAUL ADLER

Paul, the last thing I would do is make drastic changes to your asset allocation, especially in retirement. If you have a 25% bond allocation with the rest in stocks, you are fairly aggressively positioned already. You might sit down with your financial advisor and talk about reducing your bond duration, which would lower your interest rate risk. If you don’t own TIPS, that might be worth swapping into. Finally, I would be putting as much money into I-bonds as you can.

dl777
dl777
7 months ago
Reply to  johntlim

How do you invest in TIPS? A person is limited to $10,000 at TreasuryDirect.com which is a very small amount. Thanks.

Rick Connor
Rick Connor
7 months ago

John. Thanks for an intriguing article. Great food for thought.

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