Broker Check

Bond Funds and Tornados

| April 20, 2013
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I grew up in the Texas Panhandle.  My dad was a fighter pilot and apparently, the dry, flat, desert location of Lubbock was a great place to locate Reese Air Force Base, a pilot training Air Force Base (that is now closed).  Lubbock, like all cities, has its pluses and minuses.  On the plus side: friendly people, Texas Tech University, Prairie Dog Town and the birthplace of Buddy Holly.  On the minus side: Tornadoes.  Tornado season runs from about March to June in Lubbock.  I remember the tornado drills that we would practice in school.  The school principal would get on the address system at random times in the spring and announce that we were about to have a tornado drill.  The bells would ring and we would all march orderly by classroom out into the hallways, assume a fetal position crouched down on the floor, and wait.  Once the bells rang, again we went back into the classroom.  Because many classrooms had windows and the hallway had no windows, the logic was that we were much safer in the hall.  Of course, the most dangerous thing you could probably do is run outside.

Currently interest rates in the marketplace by any measure (mortgage rates, bond fund rates, savings rates, fixed annuity rates, money market rates) are as low as they have been in 40+ years.  Bonds are typically considered conservative investments when compared to stocks due mainly to the historically low volatility of bonds.  In fact, using bonds (Actual individual bonds, or bond mutual funds or exchange-traded funds) within a portfolio as part of an asset allocations strategy typically makes good diversification sense.  Currently diversifying a stock portfolio using bonds is much more challenging than in the past.  The simple mathematics of bond investing state that when interest rates rise, bond values drop.  While it is difficult to forecast how high a stock price will go, it is easy to predict how low interest rates can go: 0.00%.  Using Treasuries, today a 1-month bill yields 0.03%, a 6-month bill yields 0.10%, a 2-year Note yields 0.27%, 10-year Note yields 1.85% and the 30-year Bond is at 3.04%.  That is right; today you can lock in a 30-year rate of 3%.  After adjusting for inflation (which also historically averages around 3%) and paying income taxes, an investor would be locking in negative purchasing power.  Insane, right?  However, wait, it gets worse.  The sensitivity that a bond's price has to a one percent change in interest rates is called "Duration risk".  The higher the duration, the higher the interest rate risk is.  Duration risk is currently insanely high.

The largest taxable bond fund in the US today is the PIMCO Total Return fund, a fund I also happen to use in client portfolios.  As you can see from the table above, the fund currently has a duration of 4.77 and a yield of 1.73%.  To simplify, if interest rates go up 1%, this fund will drop almost 5% in value.  But no worries, because it does pay interest at the annual rate of 1.73%.  All things being equal (which they never are) you would just have to hold the fund for just less than 3 more years and you will be back to break-even (1.73% a year for 2.9 years = 5.01%).  This is oversimplified, but you can see the problem:  The Risk/Reward equation makes no sense.

I have been reducing duration risk in the investment portfolios I manage; however totaling exiting bonds now is not feasible either.  Predicting interest rate movements is a fool's game and not part of my job description.  Managing risk in my client's portfolio however, is part of my job.  Those mortgage refinance ads two and three years ago that stated "mortgage rates are at 30 year lows and will only go up, so refinance now!" were wrong.  Mortgage rates dropped even more in 2012 hitting new lows.  Perhaps some investors have been lulled into a false sense of security with bonds.  JP Morgan reported this past January that global retail investors bought close to $680 billion in bond funds in 2012, establishing a new record and also making the gap between bond funds and equity fund buying the highest on record.  This reminds me of 2000 and the technology stock bubble.  Technology stocks were trading at the highest valuations in history.  Technology stocks represented over 35% of the S&P 500 in 2000, the highest weighting ever for any industry group.  yet I remember my phone would not stop ringing at the investment firm I worked at.  People were coming out of the woodwork wanting to buy the latest tech stock IPO or anything with the word ".com" in the name.

I learned as a kid in Texas that a tornado would never "sneak" up on you.  Tornadoes are spawned from severe thunderstorms.  A "tornado watch" is then issued when atmospheric conditions are favorable for the formation of tornadoes in a given area.  Then comes the "tornado warning", which indicates that a tornado has been sighted and is a certain threat to a given area.  As a nine year old boy I survived one of the worst tornadoes in Texas history, the famous May 11, 1970 Lubbock tornado (Actually two tornadoes that converged upon the town at the same time).  Mom threw us four boys in the hall closet when the radio issued the tornado warning.  Twenty-six people were killed and an estimated $250 million in damage was done. 

The warning has been issued.  Duration risk is extremely high.  Bond valuations are unrealistic from a risk/reward standpoint.  There is no need to panic, but ignoring the risks in the current bond market today would be the equivalent of running outside during a tornado.  Just like my mother putting me in a safe place out of harm's way, investors here may want to shorten the duration risk on the bonds in their portfolios.

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