
When you hear about investment opportunities nowadays or when you listen to advice from your friends or family regarding investing, you could hear terms like real estate or stocks. The term cryptocurrencies are also very likely to be the topic of such a conversation. Even in the news, stocks and cryptos are the most popular assets you can own. But what happened to bonds? They have apparently vanished from the spotlight in newspapers and don’t get as much attention as other assets. A couple of decades ago, trading bonds was considered lucrative. Value investing legend Benjamin Graham advocated for a perpetual presence of bonds in every investor’s portfolio. But why are they not as popular as other assets? To understand why bonds have disappeared from the spotlight, we need to look at what a bond is in the first place.
Bonds – the basics
A bond is an asset issued by an institution or most commonly a country. US treasury bonds, for example. Bonds can also be issued by firms, municipalities and other institutions, but this article will predominantly focus on US T-bonds. Let’s look at how they work: A bond is a reverse lending device. Usually, when you want to get a loan, you go to a bank, and if they think you are a “secure” borrower, you will be given a loan with an interest rate that you have to pay. Bonds are a way for the issuer to get a loan from you (who buys the bond) with an interest rate that they themselves determine. When you buy a bond, you give the issuer a principal payment and they in turn give you an interest rate on the principal payment. When the principal has to be repaid (or when a bond matures, which can be up to 30 years), you get your money back with the interest rate that they paid every year, also known as the yield, being your profit. Bonds have a measure of how safe they are, called a rating (the most popular firms, assessing a bonds safety are Moody’s and Standard and Poor’s). The best rating is AAA, which is the rating of US T-bonds and the rating of some European countries’ bonds. Bonds have a price and a yield. The price goes up when the yield falls and vice versa. Mind you, prices are determined on the bond market, where prices can be higher or lower than the principal payment. Bonds are used by the fed when they want to let money flow into the economy. The Fed buys bonds to give/lend firms money to work with. The Fed is currently restricting monetary policy because of inflation and buying bonds would make things worse for them. Now that we’ve determined what bonds are, let’s look at the state of how bonds and the economy usually work.
Bonds, the economy and the stock market
Bonds and the stock market are in an ever-lasting competition for capital. Bonds offer a low(er) yield but a very safe return. Stocks are volatile but are considered safer when the market is doing well. The battle between stocks and bonds is thus dependant on the state of the economy. It hasn’t helped that housing prices are up and cryptos are more popular than ever, stealing capital from both sectors. The general possibilities are:
The prospering economy: Because of little risk, people put their confidence in stocks to do well and stock prices rise. Bonds are neglected and their market prices fall. In turn, their yields rise.
The recession: Stocks are considered too risky and their prices fall. Bonds are a safe investment and offer refuge in a time of volatility and uncertainty, their prices rise, but their yields fall.
The stimulated economy: During the mid/end- stage of or after a recession, the government sets low interest rates to help the economy recover. Provided this doesn’t lead to inflation, bond prices and stock prices rise, leaving bond yields to fall. Bond buying programs play a key role in the rise of bond prices.
Inflated economy and high interest rates by the Fed: When stimulating the economy results in inflation, interest rates are set higher and bond buying programs come to an end. Stock prices and bond prices fall (somewhat, as seen in today’s markets) or stagnate and bond yields rise.
After 2008, we were living in a stimulated economy. Money that is circulating was predominantly supplied by the central bank and bond buying programs ensured the security and rise of bond prices. In terms of yields, however, bonds have performed very badly. The low yields of bonds (In Germany, there are even negative yields!) has made them a questionable investment, for the sake of steady income, at least. If one is willing to buy bonds for steady and safe income, one should assess their financial situation, in order to see whether the purchase of such an asset, is worth the work. In 2021, after the Covid-19 pandemic (at least, the beginning of the pandemic), supply-demand chains were delayed, causing prices to inflate. People currently want products that firms are not able to provide quickly. Hence, the ongoing inflation. Obviously, this period is a classic example of an inflated economy. Stocks, while not having crashed, remain stagnant. For context, the Dow Jones rose approximately 65% from the “crash” (a debatable term) in early 2020 to 2021. From 2021 to 2022, that figure is approximately 20%. Of course, the Fed has imposed inflation measures. Yields have started to rise along with the Fed’s interest rate, which has hurt stock prices. Raising interest rates generally hurts stocks, because the costs for the company to borrow money has risen, making running the business and generating profits more difficult.
In terms of the development of bonds, one must take this into consideration: The rise in bond yields was mild, but will continue. Its ability to ensure stable gain over time may slowly return, as inflation continues. Its price on the market will continue to drop, though. Note, however, that inflation will carry on for no longer than, say, about 5 years. This is the time that it will likely take for the Coronavirus to be somewhat under control and for the supply-demand crisis to balance out and for businesses to come to their senses and stop rising prices. After that, the stimulation of the economy will continue. That doesn’t mean the impacts of potentially high-yield bonds will not be noticeable: Bonds are long-term and the effects of high yields should be considered as such, too. Also, one should take into account the likelihood of a stock market crash and the effects this could have on long term assets. What we are experiencing regarding bond yields and stimulation at the moment is a fairly new occurrence. To put this in to perspective, I will show you the opinions of two stock market legends, regarding bonds. One is Benjamin Graham (1894-1976) and the other one is Warren Buffet (1930-).
Expert opinions
Benjamin graham was a strong advocate for bonds. He was of the opinion that every investor, no matter his attitude toward the market, ought to invest some percentage of his funds in bonds, ranging from 25-75%. The other part of his portfolio ought to be dominated by stocks, I won’t mention other assets that he advocated for here. Note that at the time, investors still relied heavily on the dividends of stocks for passive income. Nowadays, the main profit that investors draw from stocks is the immense growth in the stock price, since firms argue that instead of paying dividends, they should use the money to reinvest even more and squeeze out profits. Graham thought that when the investor is uncertain of the stock market because he is, for example, unwilling to pay for rich valuations, he should sell a large percentage of his equity and enter into the bond market with more money. If he however has a good feeling about the stock market, he should invest in stocks. This balance, if you noticed, goes hand in hand with the bond rules: the prospering economy and the recession. But why can we not follow this rule any longer? It’s because since 2008, the economy has been stimulated by the government, causing bond and stock prices to explode, destroying bonds as a fixed income asset, as the yields declined. As a general rule: The riskier the bond (or the institution issuing it), the higher the yield, since the investor needs compensation for the higher risk.
What we are experiencing at the moment is anything but normal and your investment strategy should be considered as such. Much of what you heard in old investing books, including Graham’s work, may not be applicable to today’s economy. That is not to say that you shouldn’t read old investing books, you will find a lot of timeless advice in them, too, but you need to approach them with a different mindset.
This is illustrated by the opinion of his student, Warren Buffet. Buffet advocates for people to exit the bond market, because of the reasons listed above. The original purpose of a bond, the “reverse lend” doesn’t work for the investor any longer. The companies do not care because of bond buying programs, or at least they didn’t use to. With inflation, they are starting to, but the effects of the long bond buying are still in effect to this day. The decline in bonds yields started when interest in bonds skyrocketed in the 70s and 80s because of intense globalisation. This ultimately led to the bond’s downfall as a fixed income security.
Will inflation effect all of this?
In the next months, not all too much. In the next years: definitely. Inflation will have an effect on the rise in bond yields, but once that is over, no one can really say what is going to happen. Bond yields still aren’t high enough to call them good fixed income investments. Corporate bonds are risky, especially now that the US government is tightening monetary policy. They are thus not appropriate for market speculation. The thing is: Bond yields will continue to rise in the near future. And once they actually are high enough, you could assess their risk and invest. Keep in mind that an end of high inflation should be in sight at the very least. Yields may rise because of inflation but their value is also diminished at the same time, because the same yield will give you less money over time.
Bonds: the pros and cons
Now that we discussed everything else, let’s talk about the benefits and disadvantages of bonds, if you were to buy them at this current time:
Pros
o In contrast to cash, your money is at the very least somewhat inflation protected. If you are willing to invest in riskier bonds at a higher rate, that protection could turn into actual profit (less and less, though, over time). Just know that the risks will be extremely high, especially at this time. The lower interest of short-term bonds doesn’t yield enough profit.
o Bonds, especially government ones tend to be more secure than equity investments.
o U.S. Bonds and western bonds have the countries’ economy standing behind them. Even though the return isn’t lucrative, no other investment has this level of security.
Cons
o They are extremely vulnerable to inflation, especially at this time. Whilst protected a little, a lot of other investment choices exist and should be considered. Wait for higher yields before investing for steady profit.
o They suffer from historically low yields. In Grahams time, the bond was a must-have in your portfolio. Times have changed quite a bit since.
o Equity yields a higher return. If fixed income is still a priority, dividend stocks might be an option, since they grow more in value and yield annual dividends. Right now, companies are a bit strained though, so don’t always count on their ability to pay those dividends.
o The increased use of quantitative easing has jacked up the price, and with yields rising in the near future, selling an overvalued bond will almost certainly lead to losses. Buying a bond at this time entails not expecting prices to rise soon.
Bonds might be more useful in a couple of years, since high yields are still a possibility. Another big reason for the importance of bonds is historical. Its role in the historical financial markets has become so important that for some investors, it’s almost “tradition” to invest in them. The other historical reason is the innovation of bonds. The bonds that I’ve talked about have been standard run-of-the-mill bonds. What about other forms of bonds?
TIPS
In this post, I will only discuss TIPS, as that is the asset that many people are thinking about buying during times like these. The selling point for TIPS in times like these is that they protect against inflation. That is why TIPS stands for Treasury-Inflation Protected Security. Treasury refers the USA, which means that it is secure in that regard. However, these securities also have their problems. Normally TIPS have lower interest rates than Normal T-Bonds. However, once inflation starts to rise, the yield increases. So, just buy this one, right? Well, wait. TIPS have two major problems. The first one is that investing in a long-term TIPS right now could not be as profitable, since the yield decreases with deflation. If Inflation only lasts a couple of years, one should invest in shorter term TIPS. This decreases the rate, of course (The longer the term, the higher the yield, because longer terms are more unpredictable and risky). If inflation returns to its normal state, the small yield wouldn’t be that profitable and if deflation ensues, you could actually lose money. But say you do actually somehow make it work with the yield. There’s still the tax problem. I won’t get into it too much but in simple terms, with TIPS, you can be taxed for money you haven’t even received yet, because TIPS gains are taxed as normal income. This tax situation makes TIPS unsuitable for regular investing. However, putting them into a retirement account that has tax benefits and could protect your money from any kind of inflation in the long-term. Be careful of investing in these assets before a deflation, though, it may come back to haunt you. Other than that, though, if you make smart decisions regarding taxes, you’ll have some money from your retirement account safe from inflation.
Final Verdict: are bonds worth the work?
For most people, the current answer is: no. Times have changed since the 80s and since 2008 and bonds are no longer the holy grail that Graham and many others from that time have made it out to be. Their glory days may return after the pandemic, but we will have to see. TIPS can be profitable in retirement accounts and might be the only way you would invest in any kind of bonds at the moment. (Note that at the moment really does mean right now. If there will be major changes in yields in the near future, there will probably be an article about it.) Inflation has made bonds uncertain and what comes after that is too. When yields do rise and you think that they could work for you as steady income without default risk or inflation risk, they are worth considering as a viable investment.
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