Building the Case Against Bonds
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Global bonds rallied in February and March, giving the unfortunate illusion that bonds are an important part of a portfolio managed to a fiduciary standard. But there is no justifiable reason left to take on the duration risk (and potentially the credit risk) of domestic and foreign Treasury bonds.
Only complacency and fear of change keep Treasury investors entrenched.
Investors have historically owned sovereign and investment-grade debt for a few reasons:
- It provides a core base return for their overall portfolio.
- It is expected to provide positive returns during equity sell-offs.
- They’ve always allocated to bonds.
- Allocating 100% equities is too risky. (Cash and equities are the only two relevant liquid allocations, unless you have access to high-quality, liquid alternatives)
While these reasons have been true in the past, much has changed. Bonds no longer provide an attractive base return, with current 10-year yields less than 1% and a majority of sovereign debt yielding zero or less. The positive returns during spring’s equity sell-offs were merely a mirage generated by federal intervention rather than from natural market forces.
Having any sovereign or investment-grade debt is a bad investment decision for the following reasons:
- Historically, the 10-year note yielded at or above realized inflation. Given inflation rate expectations in the next 12 months of close to 2%, this implies a loss of 10.1% given a duration of 9.44 years on 10-year Treasury bonds.
- Current inflation rates are 1.5% +/- with all the kindling to drive it higher, not lower.
- The buyer base of Treasury securities is drying up with the Fed being the buyer of last resort.
- The Fed artificially creates low rates and demand in times of crisis to add liquidity to the system.
- Investors are fatigued trying to short the Treasury market for the last seven years. Complacency is high.
- Investors forget the muted response of Treasury securities to the sell-offs in February 2018 and the third quarter of 2015 when the Federal Reserve was not there to prop up bonds.
- The market dynamics supporting equities, zero interest rate policy (ZIRP), and extreme liquidity is unsustainable policy that makes both asset classes prone to the same risk.