I've gotten a lot of questions lately about my call on bonds being overvalued and how to action this. Here are my thoughts:
Rates are extraordinarily low throughout the developed world and for good reason. Equity markets just entered their quickest bear market on record (down >20% in 19 days), central banks are cutting rates hand over fist, demographics are terrible (falling birth rates and aging populations)....oh, and did I mention there is a pandemic currently taking hold of the global economy?
Anyway, all of the above should lead to lower rates and slower growth. Bonds should do well in that type of environment. The problem is we are starting from close to zero so, unless deflation takes hold, I think it’s tough to make the argument that you’re going to earn anything above your stated yield (which is extremely low) from here on out.
So what do we do? Simple...three things:
Shorten duration - the risks around rates right now are asymmetric in my view. If I’m wrong and rates go negative in the US, you might pick up a small additional return by buying longer bonds. If I’m right and rates go up even a little from here, you stand to get hit pretty hard because every portfolio I see these days has allowed duration to creep up since interest rates have been a one way trade. The upside just isn’t there anymore and the downside over the course of the next decade or two is potentially pretty ugly. I think rates probably stay flat for a while longer but they will have to move higher if we stand any chance of reflating our way to growth.
Get liquid - were starting to see pockets of illiquidity in certain bond markets. Liquidity is like oxygen - you don’t know it’s there until it isn’t. We’re starting to see pretty dramatic spread widening in corporates and junk is obviously getting crushed. Munis have held in ok but spreads are widening in smaller deals and just this morning we're starting to see the asset class move lower. I would blow out of these smaller deals and stray towards the bigger, more liquid ones. You’ll give up a few bps in order to do so but I think the safety trade is worth it right now.
Upgrade credit quality - this is simple. Look at the BBB part of the market. We’re going to see a wave of downgrades there. It’s inevitable. Get out of that stuff now (if not sooner!) and do your homework going forward. No more free lunch...this market is about to get interesting again.
Most advisors out there aren’t going to tell you to do the above because it probably means you end up sitting in short duration Treasuries, cash, and other instruments where they can’t make any money but I’m not most advisors. You're about to see some things happen in markets that will be somewhat goofy. As leverage unwinds, it usually takes prices lower with it. So get your A game ready and be opportunistic.
Here’s the last thing I’ll say and then I’ll shut up:
In an up market, everyone is a genius. In a down market, you’ll learn that no one is.
Expertise matters. Call me.