Has the bond market reached the boiling point?
July 24, 2015
Market Summary – 2nd Quarter, 2015
“The safest road to hell is the gradual one—the gentle slope, soft underfoot, without sudden turnings, without milestones, without signposts.”
~ C.S. Lewis, “The Screwtape Letters”
An old anecdote tells us that a frog dropped into a pot of boiling water will immediately jump out of the pot. However, if the frog is placed in a pot of cold water that is slowly heated, it will not perceive the danger, and will remain in the boiling water until it meets its demise. It is a metaphor for the inability or unwillingness of people to react to gradual, rather than sudden, threats. It is an appropriate allegory for today’s bond investors and dividend seekers, who are beginning to feel the heat.
After 10-year U.S. Treasury bond rates dipped to 1.68% on February 2nd, yields rose by 67 basis points, or 0.67%, to 2.35% by June 30th. Keep in mind that bond yields move inversely to bond prices, so rising interest rates result in falling bond prices. This 40% change so far may have gone relatively unnoticed by many bond investors, just as the frog fails to perceive that the water temperature is slowly rising. Bond investors may not have yet detected the heat from these gradual and seemingly modest interest rate moves, but the damage done so far is indicative of the risks that await them. The price of a 10-year U.S. Treasury bond has fallen by nearly 6% since February 2, 2015. If the gradual uptrend in bond yields continues, as we expect, losses will continue to accumulate. And there is plenty of room for rates to continue to rise. Yields on 10-year Treasuries today are still at a lower level than they were for the 50 years leading up to 2008, and nearly one-third of the recent historical average of close to 7%. An increase in interest rates to this historical average would result in the price of a 10-year U.S. Treasury bond falling by about 35%. So much for a safe investment.
A number of investors, dissatisfied with the low yields produced by bonds, have turned to bond “proxies,” defined as stocks of generally low-growth companies that pay out most of their earnings in the form of dividends. Yet these investments are struggling as well. As interest rates rise, yields on dividend-oriented stocks become less competitive. As an example, for the year through June 30th the S&P 500 Utilities Index (a popular bond proxy) has declined by 10.7% on a total return basis. Another income alternative, real estate investment trusts (as measured by the MSCI U.S. REIT Index) are down more than 6% on a total return basis. By comparison, the stock market has been relatively flat over the first half of 2015. The notable losses in bonds and bond proxies resulting from what to date are meager interest rate increases should serve as a warning to investors that the risk in these perceived safe havens can be significant.
What causes higher interest rates?
The rise in interest rates reflects continued improvement in the economy. This growth is accompanied by the increased likelihood of higher inflation. Interest rates typically rise in anticipation of higher inflation.
There is significant evidence that the state of the economy is favorable.
- In May, existing and new home sales reached five and a half and seven year highs, respectively.
- U.S. auto sales in May reached an annualized rate of 17.8 million, with sales on pace for the best year since 2001.
- New construction permits are at an eight year high.
- The economy has added an average of 250,000 jobs per month over the past year, while the unemployment rate has dipped to its lowest level since before the recession of 2008, at 5.3%.
Additionally, around the globe, people are becoming better educated and the middle class is growing. We’re finally seeing signs of wage growth, which could create more inflationary pressure. In May, U.S. consumer prices registered their largest increase in more than two years, another sign that inflation may become a bigger issue, which would typically mean interest rates are headed in the same direction.
There’s another important factor that bondholders should be aware of – the government isn’t opposed to the moderate inflation that leads to losses for bond investors. A little spurt of inflation will result in an erosion of purchasing power, a benefit to those who have borrowed money. An inflationary environment eases the debt-servicing burden of a borrower, because the borrowed funds cost less in current dollars. The federal government would be the biggest beneficiary of such a reprieve, given that it has accumulated $18.6 trillion in debt.
What we’ve said in the past
Readers of our newsletter are well aware of our long-standing concerns regarding the excessive valuations of bond and bond-proxy investments. Our first warning came three years ago, in the 1st quarter of 2012 (“A Momentary Lapse of Reason”), when we stated that with yields so low, Treasury bonds were overpriced. In our subsequent letter (“Why Am I Here?”), we pointed out that “risk is best managed by buying inexpensive assets.” We considered excessively valued bonds to be fraught with risk and asserted that stocks of select businesses offered superior risk-adjusted returns.
Later in 2012 our 4th quarter letter (“The Great Rotation”) noted that as the economy improves, the natural cycle of things is for interest rates to trend higher. As a result, we predicted that the “tidal wave of liquidity being pumped into our financial system is an overwhelming influence that we believe will usher in a 25 year bear market for bonds.” Just two years ago in our letter for the 2nd quarter of 2013, (“The Smooth Road to Nowhere”), we focused on our growing concern that high demand for perceived safe haven investments was driving them to excessive valuations. It was, in a sense, another case of “irrational exuberance” by investors, this time for low yielding instruments that presumably offered a degree of safety.
Throughout this time period we have been humble enough to acknowledge that neither we, nor anybody else, knew precisely when the sustained rise in interest rates would begin. We only knew that they were artificially low and would ultimately rise. We asserted that we were comfortable investing in a way that is contrary to popular conventions, because we believed that it provided the best protection for our clients from the dangerous excesses of the market. As a result, our clients have avoided and continue to avoid many of the losses experienced by bond and bond-proxy investors.
Now that there appears to be a gradual progression towards a normalized interest rate environment, we believe that we have positioned our portfolio not just to protect our clients from the market’s excesses, but also to benefit from overlooked and under-appreciated opportunities.
How we are positioning our portfolio
A rising interest rate environment is a benefit to banks. It gives them the ability to earn more on money that is lent out. But not all bank stocks offer similar investment rewards. Citigroup (C, $55.241) offers exceptional value as it trades below its tangible book value and boasts one of the leading global banking franchises. It has the best-in-class capital ratios, leading the Federal Reserve to approve Citigroup’s plan to return $7.8 billion to shareholders. With many of the problems that plagued Citigroup in the past seemingly behind them, an acceleration of capital return is expected. Interestingly, one of Citigroup’s most outspoken critics in the past, veteran bank analyst Mike Mayo, is now one of its biggest bulls. Speaking to CNBC on June 5, 2015, Mayo stated, “I’ve been following Citigroup for more than two decades. This is perhaps the best opportunity in those 20 years to own Citigroup, given the level of risk.”
Innovative glass company Corning (GLW, $19.731) is appealing for a different reason. It’s just an old-fashioned bargain – a 164-year old glass company with an image problem. Investors have undervalued the company that invented Pyrex cookware nearly a century ago due to worries that liquid-crystal-display TV sales will slow or even contract in the near future. These skeptics fail to recognize that Corning has evolved into one of the world’s most innovative companies through its revolutionary glass products that provide touch screen technologies for smartphones, optical fiber to speed up internet networks, and ultra-thin glass that is expected to facilitate Internet video and 4K ultrahigh-definition TVs. In July 2015 it was announced that Corning had provided critical, high-precision components to imaging system of NASA’s New Horizon mission. The unmanned spacecraft’s Ralph imager has returned the closest-ever color images of the Pluto System. A prodigious free cash flow generator, Corning has about $1.50 a share in net cash (cash less debt) on its balance sheet and has managed to buy back 12% of its shares since 2011, while also raising its dividend four times. Factoring in the excess cash on its balance sheet, Corning trades at just 10 times projected 2017 earnings.
What if interest rate increases aren’t gradual?
While the shift to a more normalized interest rate environment is expected to take place gradually in response to a continued gradual improvement in the economy, the lack of liquidity in the bond market could cause a more sudden change in interest rates. If this occurs, the subsequent losses to bondholders will be much more severe than most expect.
Lack of liquidity affects price, and bond market liquidity is materially lower than it has been in years past. Consider that a year ago banks could trade $280 million of U.S. Treasuries without causing a significant price movement; today that threshold has fallen to around $80 million2. The most likely cause for this liquidity decline is that the Federal Reserve ended its quantitative easing program, which consisted of massive bond purchases. Many institutional investors had been following the Fed’s lead, and the absence of these buyers in the market, along with increased banking regulation from the Dodd-Frank Act, has significantly reduced liquidity in the bond market.
Another concern is the proliferation of mutual funds and ETFs as a favored vehicle for bond investors. Bond funds are marketed as liquid investments, yet the bonds underlying these funds are not. If redemption rates increase significantly, the process will be much like people trying to exit a packed movie theater all at once. A flood of sellers will dwarf the number of buyers, setting up a scenario where bond prices fall and yields escalate. After years of positive cash flows into bond funds, the tide may be turning. During one week in mid-June, outflows from fixed income funds were the third highest ever3.
A time to search for selective value
The stock market is likely to face some challenges in the coming months. Investors are jumping from one boiling pot to another – from Greek and Puerto Rican debt crises to Federal Reserve interest rate hikes to a potential bond market meltdown. What can easily be lost in the swirling waters of financial headlines is that the economic underpinning for stocks of select companies remains solid. In an environment that combines volatility and opportunity, a discriminating approach to stock selection is critical.
Those who tend to follow the herd and favor the “investment du jour” can often find themselves in the wrong place at the wrong time. Investors who put money into an S&P 500 index fund in early 2009 may have fared well over the last six years, yet they would have been in the wrong place (compared to many actively managed funds) had they used the same approach just six years earlier, in 2003 – earning a negative 1.7% cumulative return4. It is important not to be caught up in a short-term bias, thinking what’s worked recently will continue to work going forward.
The market is likely to deal with some unpredictability and volatility in the months to come. Financial troubles in Greece and Puerto Rico may cause a temporary influx into U.S. Treasuries, raising their prices and thereby lowering their yield. However, we believe that this will only be a temporary response. Over the long-term we believe that rates will be noticeably higher from current levels.
What the headline writers missed
Popular media reports more on stocks than bonds. Because of this tilt, broadcasters pontificate primarily on the risks of a stock market correction. The reality is that income-oriented investors can’t afford to overlook the critical issues that are rapidly coming to a boil in the bond market. For those looking for a cushion against risk, paying attention to price is the best defense. We maintain that a selective approach to the stock market is the avenue to execute such a strategy.
2015 MPMG Speaker Series event: An Officer & A Gentleman
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The invitation-only event, which promises to offer a lively discussion and insight on these challenges, will be held on August 20th at Golden Valley Country Club.
1) Price as of 6/30/2015 close.
2) J.P. Morgan, per CNBC broadcast on June 11, 2015.
3) Akin Oyedele, “It’s a Bond Market Exodus,” Business Insider, June 19, 2015.
4) Robert Capanna, “Who Beats the Market? When? How?,” Barron’s, June 20, 2015.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.