Current Bond Environment
While May was a really good month for equities, safe heaven instruments also held on. Leaving May, there has been a big debate about the disconnect between the stock market and the underlying economy, and most of the world is fixated on the equities and bonds to get a clue of what will happen. Furthermore, Federal Reserves' recent decision to actually start buying bond ETFs like JNK, HYG, and to backstop the bond market, has given the impression that the bond yields will not go higher and the prices will not come down, as the Fed is there as a major buyer.
This might be true in the short-term. However, one should seriously re-evaluate the future of bonds because bonds impact every part of the society ranging from corporations to governments, from individuals to investors, and are a fundamental component of many portfolios driven by the modern portfolio theory. If there are underlying reasons for the bond market deterioration, the Fed might be forced out of its buying position. Therefore, one important question to ask right now is: Is this the time to take the opposite side of the bond trade?
Historical Context
Before we start and think about where we are today, it is important to understand where are we coming from. In the case of bonds, we have seen almost 40 years of increasing prices and falling interest rates. People who bought houses in the 1980s know that the interest rates were in the teens. That was a period of significant inflation. Since the early 1980s, the pendulum of the interest rates has swung in the opposite direction. While the US interest rates are still not negative the global interest rates in many of the developed world turned negative in the last few years.
Historically, there is a 60-year cycle prevalent in the bond market. This time around, the bottom of the cycle has been elongated by ~10 years due to government interventions. But it also means that there is lesser time to see the rise in interest rates, which would suggest a sharper rise in the interest rates could happen when it starts.
Government Interventions and Extreme Behavior
We have seen government interventions in the form of the Fed’s QE programs or European Central Bank’s bond purchase plans, but these programs took a very different and aggressive shape since the onset of the Covid-19 crisis. The Federal Reserves started buying junk bonds and corporate debt at a time when the underlying companies don’t have any earnings to finance their functions. Companies took full advantage of this program and have raised record debt in the past couple of months to stay afloat during the crisis. At the same time, governments around the world have taken out an unprecedented amount of debt to stimulate their economies.
Just to give an example of the government’s spending spree, one can look at the United States where the national debt has doubled in a matter of years. This increase in debt was driven by deficit to support the tax cuts and then to support and stimulate the economy through the Covid-19 crisis. Similar to the US, there is global coordinated money printing going on to stimulate the economies.
Even with all of this extra-ordinary spending, the interest rates remain extremely low. This is not a normal behavior because typically interest rates go up in response to higher loan amounts because they reflect the risk associated with the ability to pay back the loan. This is also visible when one takes out a personal loan. If the credit score is high, lower interest rates are offered and if the credit score is lower, they have to pay higher interest rates. Now consider the scenario where there are many defaults of businesses and individuals reducing the tax receipts, in turn limiting the ability of the governments to pay off debt or even resulting in sovereign defaults. This is a fundamental problem with the market right now.
Key Strategic Questions and Implications
Therefore, one should understand and consider a few key questions to form a perspective on the bond market and understand the risks associated with it:
What happens when the bond market investors realize that the debt taken out by the companies and the government is just too high to manage?
What happens when the interest rates start going up and debt servicing charges become too high?
Till what time can the Fed support failing businesses by purchasing junk bond ETF's?
Under these circumstances and knowing the risks that are involved it is very important to have a good understanding of what is happening or could happen in the bond market with clearly articulated risk management parameters. It is apparent that whenever the bond market realizes that the debt taken on by the governments and businesses is just too high to manage, interest rates will go up.
When the interest rates start rising it will become difficult for the governments to raise more debt to service existing commitments it will also impact the government's abilities to provide additional stimulus into the economy. In fact, it might come to a point where reducing benefits and steps like sequestration might come back onto the table. Lastly, it impacts the ability of Treasury to backstop the federal reserves in purchasing bonds and other ETF's, which for now is a backstop to the economy.
Analysis suggests that there is a very high possibility that the bonds have topped and the interest rates will start to move up soon. If this analysis is true, this has significant implications for individuals, businesses, investors, and governments:
If the interest rates go up, it will be even more difficult to raise money for the businesses and as a result, many companies might go under
Higher interest rates will force the governments into austerity, prolonging the downtrend
For individuals, it means that mortgage rates and interest rates will go up. As a result, big purchases might be delayed. Now is a good time to refinance mortgage or access home equity at lower rates. Few major banks have already stopped providing home equity lines of credit.
For real estate investors, the real estate market could enter a prolonged downtrend as demand evaporates with higher interest rates. This might not happen overnight as the housing market wasn't as overstretched as was in 2005.
Investors have two distinct options and scenarios:
Remain long and maintain bond exposure to protect against economic uncertainty and hedge against potential downside in equities with the risk of the possibility Stocks and Bonds both can decline in unison.
Invest to gain from a bond market decline. Just to be clear, shorting is difficult because it could result in unlimited losses and therefore is not recommended for average investors.
Investment Approach
Penta Capital is positioning its portfolios to take advantage of this paradigm shift where bonds transition from rallying for 40 years to a potential decline. Now is a good time to start these opportune portfolio positions as the bonds are still hovering around their highs. Once the decline starts, it will be sharp and a lot of people will not get the right entry, and those who are long, might not be able to get good exits.
At Penta Capital, we diversify and hedge our portfolios to ensure that the positions are not concentrated in one area. While for many this might be a counter-intuitive trade especially with the federal reserve's buying up junk bond ETFs, this type of difficult trades is the ones that result in substantial gains over time. We can see that there are structural problems arising in the market and one should remain cautious. The actual positioning and risk are managed by algorithms to ensure that the portfolio is protected in case our hypothesis is negated.
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