Is There A Bond Conundrum?

Bottom-To-Top (BTT) vs. Top-To-Bottom (TTB) Approaches

“Investment strategy is the prime factor to make investments successful in the long run as well as in the short term. There are two competitive approaches: one is a bottom-up one and the other is a top-down one. The former depends upon security selection and market timing. The latter focuses on reliable long-term portfolios.

The latter approach is, first, to look at macroeconomic aspects such as economic growth, economic policy, inflation, business cycles, and interest rates. Second, it determines asset allocations between equity, bond, and other alternatives. Third, it selects individual securities such as individual stocks and bonds, or exchange-traded (or mutual) funds.

Traditionally, a top-down approach has been exclusively used by institutional investors such as mutual fund companies, banks, insurance firms, college endowments, and pension funds. Individual investors cannot afford to meet significant financial and technical resources, required.

The investment world, however, in recent decades has made a top-down approach available to retail investors, providing low-cost trades (with no or near-zero commission) and investment vehicles (such as index mutual funds and their ETFs, and other low-fee actively managed mutual funds and ETFs).” (Source: “Ten-Year-Treasury Yield Curve.”)

A Bond Puzzle?

One of readers on “Investing In The Last Years…”, NextGenInvest, offered the following comment:

“I know that people who say ‘it’s different this time’ are pretty much never right and look silly in hindsight. However, the interest rate environment coming out of the financial crisis until recently has also been unprecedented. Never in history were rates that low for that long. So, if the facts change as they say, so should our thinking.

So, it seemed reasonable to me that deviating from the traditional 60/40 that made so much sense in the past no longer made sense when the 40 was earning near or around 0% interest. Bonds in the past would act as an anchor for a portfolio when equities fell. But, in recent years, bonds seemed to have fallen as well. So, it seemed reasonable to question what their purpose was.

Now that interest rates are climbing to something more reasonable, I find myself as a new investor needing to revisit the bond idea. I am still very confused. If something like BND yields 2.67% then why not just put my money in T bills yielding 4+ percent? It’s not like bonds are rising as stocks are falling……so, what is their purpose again? BND is down 13.53% year to date. So, how are they helping to steady the ship vs 100% equities?” (From NextGenInvesst’s comment, a few editing added)

The Author’s Reply

I, as the author of the article, replied to his well-timed and insightful comment, regarding the “lost-years bond situation” (emphasis added):

“First, the investment environment in the early 2020s is quite different, compared to the prior years of the Great Recession and Pandemic Recession (the former was the deepest one since the Great Depression, while the latter was the shortest one).

As a result, we have to adjust our investment stance in about 2-5 years, but should update our stance year after year gradually.

Second, in your view on Bonds, I feel you look at bonds as one investment vehicle with a less-than-3-year window. Please consider Bonds (Bond ETFs, in particular) as a component of well-diversified ETF Portfolios in my Articles in a much longer term, at least 5 years.” (From my author reply, a few full-spelling added)

I do believe this important issue of Bond Puzzle or “Bond Conundrum” (a la, Alan Greenspan) is far beyond the scope of the comment exchanges, so I just started penning a new Article, titled, “Any Bond Conundrum?” In the meantime, please view the following quote from “Ten-Year Treasury Yield…)

There Were Four Reasons for the Conundrum:

First, the demand for U.S. Treasuries has been changed fundamentally since the 2000s. Treasury investors in America and abroad buy the U.S. Treasuries without seriously considering the economic conditions of the U.S. They simply need them to build their portfolios with other financial assets.

Second, export-driven countries (China Germany, South Korea, and Japan) and Oil-exporting countries (Saudi Arabia and Russia) purchased Treasuries with their trade-surplus dollars and their oil money, respectively. In particular, South Korea made an extra effort to increase the dollar reserves after the financial crisis in the late 1990s.

Third, the retirement of U.S. baby boomers started. It affects overall consumption level and Treasury demand for their retirement portfolios. The propensity to consumption of the retiree is lower than the younger, and the former allocate more Treasuries than the latter in their portfolios, resulting lower spending (and economic growth) and inflation.

Fourth, there is irony in the conundrum. The Fed really succeeded taming inflation through the leaderships of Volcker, Greenspan, and Bernanke. This is no doubt a welcome part. The other somewhat less welcome part is Treasuries become much popular for investors as a very low-risk investment vehicle. Investors believe that inflation would be very low in a long haul. (From “Treasury Normal Curve…“)

The Determination of Treasury Yields

“The yields of Treasuries are determined by the interactions between demand and supply forces in the Treasury primary and secondary markets. In the mid-2000s, the demand schedule of Treasuries was shifted upward by the four factors pointed before – (1) the enhanced demand to build long-term portfolios, (2) the increased demand by the export-dependent and oil-producing countries, (3) The baby boomers’ retirement, and (4) the “well-anchored” inflation-expectations’ irony. All these factors contribute to flatten the yield curve. The flat curve in turn misled the markets and policy makers.” (From “Treasury Normal Curve…”)

Now, all factors except the augmented demand for Treasuries (from China, Russia and Saudi Arabia) remain intact. Saudi Arabia, Russia, and China reversed their positions by selling U.S. Treasuries to cover their budget deficits or to manage their currencies. Therefore, the net effect of the four factors would be muted.

All existing Treasuries, no matter what year those were auctioned (i.e., in 1966 or in 2010) or who holds them (i.e., the Fed or Saudi Arabia) are “rolling down” as time passes. For instance, for all practical purposes, 30-year Treasury (issued in 1966) held by Saudi Arabia is 10-year Treasury now. 7-year Treasury (issued in 2011) held by the Fed is 1-year Treasury.

In general, the nearer to maturity a Treasury, the lower its yield. But because prices and yields move in opposite directions, lower yields of shorter Treasuries would gain in prices. Therefore, The Fed can rollover matured Treasuries to any duration of Treasury or to longer-term Treasuries (i.e., 30-year), if needed.

The question is who would be principal player in the Treasury market today. Investors would anticipate another Large-Scale Asset Purchases (LSAP) (or Quantitative Easing), as a “QE4.” Some would expect “Janet Put” or another “Taper Tantrum,” or possible “Negative Interests.” This kind of discussion would be irrelevant for the Fed because the Fed just started to move toward a normalcy from the radical “emergency” policy.

The Fed has an enormous holdings of Treasuries of all different durations in its balance sheet. These “stock” of Treasuries is the potent ammunition to be able to dominate in the Treasury market. The Fed would be confident to execute its exit programs which has been developed over many years. In particular, the Fed’s leaderships with Yellen and Stanley Fischer (Vice Chairman, the former MIT Professor and President of the Bank of Israel) are conspicuous.

In my 2013 article, I explained how the Fed manages the shape of the yield curve to guide toward its monetary policy goal through its “Permanent) Open Market Operation”:

In a sense, the current easy-money policies are passive. If the Fed will start exiting (or mopping liquidity) and tightening (or raising interest rates), the Fed policies will become active and more dynamic. The Fed will have Permanent Open Market Operations (POMO) in addition to Open Market Operations (OMO). The OMO is a traditional policy tool. The only difference between OMO and POMO is the former deals over-night lending rates while the latter longer-term government bonds. We experienced POMO with the Operation Twist (or the Maturity Extension Program) in 2011 and 2012. The MET (or OT) is to buy longer-term bonds, by selling shorter-term bonds. The Fed is a seller in the bond markets with this program. As a result, the Fed will be almost everywhere in the whole spectrum of interest rates, ranging from the over-night lending rate and a reverse repurchase program (coming soon) to the longer-term government bond yields. (Source: “The Federal Reserve Doesn’t Blink This Time, The Market Does.”)

The Bond Conundrum Takeaways

• Expect to be extremely crushed in the short-term spectrum for bonds. There is a clear mispricing due mainly to: a) the pandemic 19; b) the Russian-Ukraine war; and c) the Fed’s persistent inflation-curing process.

• Things should normalize, but not just in 2-3 years, as most expect, but in 5 years or much longer (i.e., 7 years.)

• As a long-term investor (a couple of decades), you can start off with any current market position (a bull, or a bear, or a “pig”), but the current unsettled market offers you a more advantageous starting point, by picking equities/bonds ETFs with better prices by the help of the Dollar Cost Averaging (DCA), every month, every year, forward.

The Concluding Remarks

SPDR S&P 500 Trust ETF (SPY) (which is S&P 500 Index ETF, and the benchmark of the global major equities) and the U.S. Economy are two moving engines trying to pull themselves back up right now, as explained in “The Stock Market And The U.S. Economy.”)

We have a very favorable market environment for the long-term (i.e., a couple of decades) for investors to become millionaires, as many investors did a couple of decade ago.

Back then, they followed local advisers in the late 1990s, but now we have the new online investing era, so that you can start, by reading my articles “Investing In The Last Years…” or “A Bear Market? Or A Bull Market?“.