The Bond Girls. Love Your Treasuries Even in a Bubble
February 5, 2015
Finished reading BAML’s report: “My Stock is My Bond”. The jist is that in a time of epically low, increasingly negative, bond yields a (perhaps the only) reasonable palliative is to give up on bonds and go all in on common stock, careful screens follow form this premise. The underlying presumptions are that 1) we are in a specifically bond bubble, and 2) when this bubble pops other asset classes will fare better. I disagree on both counts. We are, no doubt, in bubble territory, meaning that valuation will suddenly drop off a cliff. There will not be a slow unwind. It is not reasonable to think that this bubble is specific to bonds and not to all other asset classes. Given this, it is not reasonable to think that other asset classes will fare better than treasuries when they fall off that proverbial cliff.
Allow me to describe common stock, and why it will always be common, and her sisters.
Financial asset classes are like a family of sisters. Each has her own personality. Government securities (henceforth “Treasuries”) are the oldest sister, very serious and classy. Not especially charming at all, but austere with a comforting elegance in her finest hours. Nobody panics holding treasuries, at least in the last 30 years or so. Investment grade bonds are closest in spirit to her elder sister. She is warm and embracing with some edges; she always has a story to tell. Far more dignified and restrained compared to speculative bonds and common, but way more interesting than treasuries. Always has some bite and baggage underneath. High Yield debt is the playful, cute, awesome middle sister of this family. She has more vitality than depth, but there is an earthiness that gives this one a solid sense of place. High Yield is vibrant and alive. She is interesting, intense and always challenging. Common stock is charming, fun, and ephemeral. There’s always a “carpe diem” mood about this one. She can offer the most rewarding relationship, but it will be a stormy one, and she can easily end up burning you the worst of all. Call them "錢姐妹" -money sisters- in the Chinese style.
The oldest sister, treasuries, seldom turns heads. She gets taken for granted, and I get this. I have lived almost entirely within a treasury bull market—I was a little kid during the last admittedly vicious, bear market. It makes sense that people would always count on her to be around at a moment’s notice. Treasuries are good to have in good times and bad.
I remember in the late 1990s in Dallas: times were fantastic and the internet was creating a new economy. The Dow was going straight-shot to 40,000 because everything was in transformation mode. Retail outlets and other stores were to be a thing of the past, to be replaced by cheap websites and drop-shipping. Work was going to be completely changed too. Dreary office cubby-holes would be a thing of the past, replaced by working from home via VPN. The dark-side was that sunshine-loving, sociable people looking for human contact and friendship would undergo metamorphosis into pale, socially inept hermits that prefer anonymity and seclusion.
Given the prospect of a completely changed economic landscape, the investment conclusion was simple. Hold equity and treasuries, eschew corporate bonds. Why the stocks? Because you can buy shares of ten companies and even if nine out of those ten go BK and worthless the survivor can have a 1000% payoff. That is something a bond could never do. Why treasuries? Because it doesn’t matter what companies survive, they still have to pay taxes, as will all those employees working from home. Taxes don’t care about your personal preferences.
It turned out this narrative was crap. In small part true, but more than anything utterly false hyperbole. The Dow is nowhere near 40,000 and it will take some serious time to get there at this rate (unless we are finally rid of that horrid thing and finally go with a meaningful capitalization weighted index). The trip will certainly not be the result of a straight-shot trajectory. Brick and mortar businesses absorbed the internet retail option to supplement their stores. Very few established retail business was replaced by it. More than anything, purely internet businesses went belly up. VPN is great and I love it, but some things like GL (general ledgers) are not for outside the office and some work functions have creativity as their life-blood. The office isn’t going away anytime soon. As for inevitable social evolution of human tribes into Morlocks, well, I’ve never seen so many extroverted, duck-face selfies nowadays.
By mid-2000, all this was a moot point. The stock market had crashed, the internet bubble had utterly crashed beyond repair and bond holders were happy with their match-making skills and their more serious-minded partners. About eight years later, was had another crash. Instead of an internet bubble, we had a credit bubble in terms of mortgages and rather complex securitizations of them. Stocks were decimated, high yield bonds were priced for sector-wide liquidation, and even investment grade bonds were flustered and disheveled. It looked like a global return to the middle ages. But through it all, the older sister treasuries was nonplussed. As always, she was admired for her composure in a crisis.
So now we are in the midst of another transitional narrative from price sensitive purchases of assets to price insensitive marginal buyers of primarily government securities. The marginal buyers are the Fed via QE I, II, and III; the BOJ via Abenomics, a very open-ended attempt at monetary inflation and currency cratering; and now the ECB purchasing already incredibly expensive EU government securities. The initial conclusion from this data is that government securities will be the hardest hit when stimulus pulls back. The narrative built around these facts is debatable, and actually an unlikely story.
The fact is that these purchases by marginal buyers represent an attempt to push money out of reference bonds and into risk. It doesn’t look to be working very well: 10Y tsy yields stand at 175 bps, JGBs at 38 bps, bunds at 37 bps, and even truly risky sovereigns like the 10Y Portuguese are only 249 bps. A part of this buying is the product of currency optionality associated with bunds in case the euro blows up. Another part of the buying of treasuries is by other countries for competitive advantage. But even give these extraneous factors; the bid indicates a risk appetite downstream from sovereign debt that is at best subdued. Dazed and confused.
When these central bank marginal buyers unwind their holding of sovereign debt, interest rates will rise for sure. As a result, risky corporate debt will sell off. So some real money will move into reference bonds, because they have no interest rate risk, possibly in enough size to fill in for the marginal buyers to some degree. And I’m supposed to think that buying common with, say, a 2% (or no) dividend instead of that name’s bond yielding, say, 8% plus accretion is a good idea? The bottom line is that the money pushed out on the risk spectrum by central bank purchases will move back in when the purchases unwind if there is no meaningful economic recovery. A move away from epic stimulus centered on government security purchases could show a risk appetite more than just subdued: Risk appetite could have a broken jaw. Unhinged and dislocated.
If you assume that there is a meaningful economic recovery and growth takes off like a champ, then yeah, treasuries will be the death of you. Well and good. Getting to recovery and growth seems pretty complicated. Any “return to normal” implies an interest rate increase is going to happen and will again dampen risky asset prices.
And the overarching theme will be fiscal retrenchment and budget balancing, and that is not risk-supportive at all. Whatever QE and low rates provide in short-term stimulus, they encourage borrowing from the future with even more indebtedness, no doubt some of it even more stupid than what precipitated QE in the first place.
Yet I keep hearing more and more about a treasury bubble and an implication that the far end of risk is the place to be. Since I am very cautious as to what this will mean for the long bond’s younger asset sisters if she does lose her cool in a bear market, this makes little sense.
Just remember that a treasury is more than a safe haven. A treasury yield is a reference rate against which everything else is measured. A high reference yield means that businesses need a higher rate of return to command attention over treasuries. So given a treasury sell off, it be no wonder that risky, non-reference assets would sell-off. And if there is a treasury “bubble”, it is no wonder that a reference rate reset would reset valuations of every other asset class way to the downside.
That is not to say common stock is always and everywhere worthless and inferior. They will always be sisters and their family will remain intact for generation upon generation despite dysfunction and dislocation. There is a place for them all in a family, happy or otherwise.