Tempted by bonds?

Yesterday, stocks had an up-down day, finally choosing up as traders bit their fingernails as they awaited tomorrow’s Fed announcement. The National Association of Home Builders Market Condition Index is falling, which should not be surprising given the industries close relationship to interest rates.

Interest in interest rates. I know you don’t like to talk about bonds. Nobody really does… or has since the 1980s when bonds were all the rage. I can remember back then, analyzing portfolios of high-net-worth individuals which were quite literally 100% allocated to bonds. These were folks who had the capacity to take risk with very long timelines, but not a single equity could be found. Today, that is clearly no longer the case in which most of those same clients, now close to over even in retirement, are 100% allocated in equities. How could such a crazy thing occur?

Well, the answer is quite simple, and I am sure you have already murmured it under your breath. It all has to do with yields. In the 1980s bond yields were downright… well, juicy, for a lack of a technical term. If you were looking to invest some cash in 1981 and you had a quick look at the markets you would see a very temperamental stock market which fell strongly in 1 of the 4 years prior, earned only +1% in another, and gained in the two years prior, one slightly above average, and the most recent with an oversized gain of +25% during a year which saw the US enter and exit a recession. The start of 1981 found stocks faltering after a strong showing in 1980, volatility was high, and stocks began to lose altitude in the summer. Inflation was high but showing signs of moderation after the Fed had aggressively raised interest rates causing the 1980 recession. In fact, the CPI was just slightly higher than today’s levels. Unfortunately, unemployment remained high, and it began to pick up, mid-year. It was clear that stocks might be in for some turbulence. Perhaps there was opportunity in the bond market. The United States Treasury issues bonds backed by the full faith and credit of the United States… the largest economy in the world. So, it is kind-of a given, despite all the wrangling that happens on Capitol Hill, that the Treasury would not miss a coupon payment or refuse to return your principal at the maturity of a bond it issued. In our industry we would never, ever, ever… EVER use the word guarantee, however, we are allowed to take some careful liberty when it comes to Treasuries. Ok, risk-free, or guaranteed return sounds better than what may have awaited investors in the stock market. So, what kind of returns could we have gotten in 1981? Are you ready for this?

How about 16% on a 2-year treasury note! That means you would get 16% per year for 2 years and then you would get all your money back (assuming you bought at par)… all guaranteed by the US Government. Now, of course the equity markets can return more than 16%, but there are no guarantees, and as 1977 demonstrated, you could lose money (-11.5%, to be exact). So, if you put yourself in the shoes of an informed investor in 1981, there is good chance that you would have selected to invest in treasuries or better yet, corporate bonds, which not only yielded more, but they came with interesting stories like equities. Of course, corporate bonds are far riskier than treasuries… a story for a different market note. What you could not have known if you chose to invest in those treasuries, that the US would enter a painful recession in late 1981 that would last through the end of 1982. The good news is that despite whatever else was going on with the economy, the stock market, or the world for that matter, you could count on getting your coupon payment twice a year and that you would receive face value back at maturity. Sounds comforting, doesn’t it?

Things changed after 1982. Bond yields came down and 2-year Note yields bounced between 9% and 13% through 1985. I know, you are thinking that those yields are still fantastic. You are thinking that, because since 1985 bond yields slowly and steadily declined. That left yield-hungry investors with very little choice but to rely on the riskier stock market, which by the way, paid off, but not without some bumps along the way. Now, we find ourselves in a very interesting period in which we have inflation that rivals the inflation of the 1980s with a today-Fed that is taking its rate-hiking cues from the 1980s-Fed. The yield curve is inverted similarly to that of 1981 and the threat of recession looms high, as it did back in 1981. As a result, the stock market is unusually volatile… but short-term yields are on the rise. In fact, the 2-year Treasury Note is just under 4%. Of course, that is not as juicy as that 16% yield you got in 1981, but it is far better than it has been since… 2007… just before The Great Recession. You may have passed on those Treasuries back in 2007, but hindsight shows us that you would have been happy to take that 4% for 2 years as equity markets plummeted and slowly began to recover. Short-maturity bond yields are higher than they have been in quite some time. They cannot compete with some of the recent annual gains in the equity markets, but as history tells us, equity markets don’t always just go up. In other words, there are no guarantees… unless of course, you invest in Treasuries.

YESTERDAY’S MARKETS

Stocks gained in a seesaw session as traders look to tomorrow’s FOMC policy announcement. The S&P500 gained +0.69%, the Dow Jones Industrial Average climbed by +0.64%, the Nasdaq Composite Index rose by +0.76%, and the Russell 2000 Index advanced by +0.81%. Bonds declined and 10-year Treasury Note yields climbed +4 basis points to 3.49% while 2-Year Notes ended the session at 3.93%. Cryptos fell by -2.66% and Bitcoin declined by -1.01%.

NEXT UP

• Housing Starts (August) are expected to have increased by +0.3% after shrinking by -9.6% in July.
• Building Permits (August) may have pulled back by -4.8% after sliding by -0.6% in July.
• The FOMC will begin its policy meeting today, but we will have to wait until tomorrow to hear the results and get our hands on the latest Dot Plot and forecasts.