Neil Young once lyricized “in the field of opportunity it’s plowing time again.” That opportunity might be in bond markets again.
Bonds’ three-decade run came to a jarring halt this spring. Everyone knew the Fed’s Ben Bernanke couldn’t keep stimulating the U.S. economy forever via ‘quantitative easing.’ But as soon as he mentioned ‘tapering’ it was like someone yelled “Fire!” in a theatre. There was a rush to the exits. The world’s biggest bond fund, Pimco Total Return, plunged from $292 billion in assets in May to $251 billion four months later: a whopping $41 billion drop. Some was market loss, but clearly many investors were cashing out and taking their winnings elsewhere.
Ed Devlin, portfolio manager of Pimco’s Canadian bond fund, says a mass liquidation hasn’t yet started in earnest. The $150 billion that left global bonds pales against the trillion-plus that found its way into bonds in the past few years.
At a recent conference, there was consensus. The U.S. still has a ton of debt—$17 trillion—requiring debt-servicing costs of $360 billion a year. But the U.S. has completed its deleveraging cycle; personal debt was reined in, real estate went through its precipitous decline and Washington hit its debt ceiling. Now the U.S. economy and jobs are recovering, albeit slowly, while housing has turned up and the government was talking about tapering its support of the bond market. Of course interest rates were heading higher!
Any time I hear a consensus like that I cringe. That’s not what makes a market. Of course, in mid-September the Fed did not taper. As one attendee said, the only time he ever saw low bond yields over such a long period was Japan between 1999 and 2013. It could happen again, but he doubts it.
To understand the case for bonds right now, I talked to Brian Miron, portfolio manager of fixed income at Fidelity Canada, whose U.S. parent is among the world’s top three global fixed-income players. He argues there are five reasons to own bonds: capital preservation, stable income, liquidity, diversification and hedging uncertainty.
Let’s start with capital preservation. Data for Canadian bonds goes back to 1986, a period of a secular bull market. There is data on long bonds before that, but it’s more instructive to look at the U.S. experience. From 1941 to 1981, interest rates soared from about half a percent to over 16%, a secular bear market for bonds if ever there was one. The worst rolling one-year return in bonds was minus 5%. The worst equity performance? Over 40%. And the instances where return was negative? 10% for bonds, 25% for equities. In Canada over the past year the total return in the DEX bond universe, despite the May to September reset, was just over minus 1%—the first negative total return since 1999 and only the third since 1986! Check preservation off my worry list.
Bonds generate lovely coupons that assure consistent stable income. In days gone by bond total returns averaged 8%. Stocks were closer to 10% but were more volatile, ranging from 5% to 15%. In the current rate environment, Myron says investors should revise expectations for bonds to 4% or less for investment grade bonds.
Bonds are usually more liquid than equities in dollar terms. When you need to get out quickly, you can.
Putting a portfolio together combining bonds with equities provides diversification. Pimco bond guru Bill Gross observes “When the Fed stops the QE game, it seems stocks might be at risk. Haven’t they more than doubled in price since 2009 in part because of it?” Gross points out bonds zig while stocks zag. Such considerations reinforce Miron’s position that bonds hedge against uncertainty.
His strategy complements all these aspects. Any given year, different fixed-income classes provide extra yield. One year it may be emerging market debt that does well, the next, high-yield bonds. These may not be correlated. So he recommends allocating funds across a range of fixed-income investments, including emerging markets, high yield, investment grade, floating rate securities, and global sovereign bonds.
Ed Devlin, the Pimco manager, says timing the market is tough. Did the bond sell-off this summer overshoot reality? Has the market overpriced a likely rise in rates? He thinks it has. The U.S. may be recovering, but does that justify potentially higher rates next summer? And will they really rise?
Ed and Brian work for the biggest bond managers in the world. They remind me of the rest of Neil Young’s lyrics: “I’ve been wrong before, and I’ll be there again, I don’t have any answers my friend, just this pile of old questions.” But they both agree that until some uncertainty comes out of the market, the best place is bonds. We may not be talking about a bumper crop in that field of opportunity…but we could be harvesting a decent cash flow over the next while.
Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitter feed is @patbolland.