Chas Craig, BridgeTower Media Newswires
While it is hard to accept the low rates of return presented by bonds, having at least some high-quality fixed-income exposure in a financial portfolio is like eating your vegetables. A large benefit of high-quality bonds is that during times of equity market stress they typically hold their value or even appreciate, at which time they can potentially be partially sold in order to buy stocks at depressed prices.
We think high-quality bonds offer more value today than they have in some time. As the bond market has sold off in recent months, with yields going higher, bonds have obviously become cheaper on an absolute basis, but in our minds they have also increased in relative value as the valuation for the general stock market has climbed. While the -3 percent return the U.S. bond market handed investors in the fourth quarter is nothing compared to the volatility one should expect from stocks, in the bond market, which is a game of inches, -3 percent over three months is a lot.
Since the most time-tested and capital destructive tradition on Wall Street is to extrapolate into the future what just happened, now, after an already very large move to the downside for bonds, financial market participants have been armed with confirmation that interest rates will continue to rise meaningfully over a rather short period of time. To this point, in the interest rate futures market the net-short open interest (bearish bets on bonds) has been near the highest levels on record in recent weeks. While we agree that interest rates are likely to move higher over the long-term, the high speed expectation of this currently expressed by the market through security prices is exaggerated in our view. Unfortunately, many of the reasons for low interest rates are still intact. While many proposed policies of the incoming administration do argue for higher interest rates, they are unlikely to fully reverse the market forces that have marked the post-crisis interest rate environment.
Plainly stated, most market participants are currently zigging in unison, which has historically proven to be an intelligent moment to zag in the opposite direction. Additionally, the spread between 10-year Treasurys and 10-year German Bunds is currently near its historic highs. On another relative value note, based on current valuations, we think investors can reasonably expect a 5-percent return from stocks and a 2.5-percent return from bonds over the next 10 years. While neither of these figures are very high on an absolute basis or relative to history (which is a large part of the case for active management), the spread between the two is in keeping with the historical premium investors should reasonably expect to earn from stocks for assuming a higher level of risk.
Therefore, after the recent run in stocks and decline in bonds, the argument that stocks are a way better deal than bonds on a risk-adjusted basis is no longer convincing to us, which perhaps presents investors with a favorable opportunity to rebalance their portfolios back to percentages that are consistent with their risk tolerances. To the extent that assets are held in taxable accounts, the new year might make incurring the likely taxes associated with rebalancing more tenable, and even more so if the tax policies being floated by the new Congress and incoming administration come to fruition.
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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).
Published: Mon, Jan 16, 2017
