The Bearish Case for Bonds

Bonds are often touted as one of the safest invest­ments an investor can make. As such, retire­ment portfo­lios are typically more heavily weighted to bonds. In fact, if you Google “Safe Retire­ment Invest­ments, ” bonds are recom­mended in nearly every search result.

The 10-year US Treasury is even consid­ered a “risk-free invest­ment” in the finance world. Yet this couldn’t be further from the truth given today’s macro­eco­nomic backdrop. There are real risks associ­ated with bonds, but many investors are unaware of them, and these risks continue to grow.

Bonds are consid­ered safe because they offer principal protec­tion. When you purchase a bond, you receive fixed interest payments over its duration, plus the principal you paid when the bond matures. This differs from a stock that can drop 30% or more and has no principal protec­tion. Investors are attracted to bonds because, unlike equities, they offer safety from a principal protec­tion stand­point and provide a stream of income via interest payments. However, there are other risks to consider.

Bonds are consid­ered safe because they offer principal protec­tion. When you purchase a bond, you receive fixed interest payments over its duration, plus the principal you paid when the bond matures. This differs from a stock that can drop 30% or more and has no principal protec­tion. Investors are attracted to bonds because, unlike equities, they offer safety from a principal protec­tion stand­point and provide a stream of income via interest payments. However, there are other risks to consider.

Infla­tion risk, also known as purchasing power risk, is the risk that infla­tion will reduce the real value of the bonds. Bonds are subject to the risks of infla­tion because interest payments are fixed regard­less of infla­tion. For instance, with a 5-year bond, you’ll receive every­thing you paid for the bond plus interest in 5 years, but if the interest payments don’t keep up with the rate of infla­tion during that time period, then you’ll lose purchasing power in real terms.

In the past, the Federal Reserve had managed infla­tionary risks by raising interest rates when signs of infla­tion appeared. Today, the Fed finds itself in a position not seen in many decades. The debt levels in the economy are so high that they now constrain the Fed’s ability to effec­tively manage infla­tion risk for bond investors. In addition, history shows us that the Fed may even want this infla­tion to occur to stimu­late economic growth. Bond investors could find themselves hurt by the conse­quences of the Fed’s other priorities.

The pandemic prompted unprece­dented policy responses from central banks and govern­ments worldwide. The result was an explo­sion of debt levels. The Fed and Congress claim these responses were neces­sary to save jobs and keep food on the table for families as the unemploy­ment rate rocketed to nearly 15% in 2020.

The world now finds itself up to its eyeballs in debt.

U.S. govern­ment, house­holds, and corpo­rate debt-to-GDP hit a historic high of 281.7%

The U.S. govern­ment debt-to-ratio currently sits at 127%, levels not seen since WWII.

When a govern­ment becomes highly indebted, like the US is today, the debt becomes a drag on economic growth. High debt levels require the govern­ment to service the interest payments of the deficit with a greater percentage of the tax receipts instead of reinvesting those funds in the economy. 

To avoid this stagna­tion in growth, histor­i­cally govern­ments have utilized a few methods to overcome an enormous debt burden:

1. Austerity measures — cutting govern­ment programs and benefits.

2. Defaulting on the debt or restruc­turing it — not paying the debt back.

3. Inflating the debt away in real terms — printing money.

The first two courses of action are extremely unlikely given the economic and polit­ical landscape the US finds itself in today. Politi­cians continue to spend money vigor­ously with no signs of slowing. A default on the debt would cause catastrophic bankrupt­cies throughout the highly lever­aged global economy.

This leaves the only remaining option to drive interest rates lower while simul­ta­ne­ously letting infla­tion run hot. By keeping interest rates low, the Treasury’s borrowing costs stay down. The low rates also stimu­late borrowing across the economy. This results in increased infla­tion and allows nominal growth to accel­erate while reducing the real cost of the debt.

By suppressing interest rates below the rate of infla­tion, the total debt is eroded in real terms. This is known as finan­cial repres­sion and is a tactic the Fed has utilized when US debt-to-GDP ratios have gotten this high.

Let’s take a trip back in time.

World War II was expen­sive. In 1942 the US Govern­ment essen­tially abandoned its monetary policy goals and spent large amounts of money to pay for the war. After the war, soldiers were returning home, and policy­makers feared that we were headed for another depres­sion. As a result, govern­ment officials deployed stimu­la­tive fiscal and monetary policies, and by 1945, public debt exploded to 110% of GDP, as shown below.

This surge in debt-financed federal spending caused a rise in infla­tion, similar to what we’re seeing today from the fiscal stimulus for the Covid-19 recovery.

Yet instead of responding to this rise in infla­tion by raising interest rates in 1942, the Fed imple­mented a strategy known as Yield Curve Control (YCC).

With YCC, the Fed pegged short-term bills at 0.38% and long-term govern­ment bonds at 2.5%, meaning that if long-term rates rose past 2.5%, they would agree to buy bonds with lower yield until the rates fell below the threshold.

They did this so that accurate interest rates would be profoundly negative and the debt would become a smaller percentage of the overall economy as the economy grew in nominal terms. This shrunk the debt-to-GDP ratio. In the previous chart, the green arrow shows how this strategy succeeded. The debt was never paid down, but infla­tion nearly cut the debt-to-GDP ratio in half from 1946 — 1955.

Without a rise in interest rates from the Fed, infla­tion ran hot in the 1940s. Annual infla­tion from 1942 — 1951 was an average of 5.8%, and in March 1947, it surged to a high of 20.1%. This caused the real yield of bonds to be deeply negative over that period of time shown below.

This ultimately resulted in the loss of purchasing power for bondholders during the post-WWII era, as shown in the following chart.

As you can see from the chart above, 10-year Treasury investors received all of their principal plus interest in nominal terms, but this was not nearly enough to keep up with the high rates of infla­tion. As a result, 10-year Treasury bondholders lost nearly 30% of their purchasing power in the decade following 1942.

Bond investors were the big losers post WWII, under­per­forming nearly every other asset class between 1942 — 1952. When consid­ering our current debt problems and the Fed’s recent policy choices, it’s hard not to feel like history is repeating itself for bond investors.

Similar to World War II, we recently saw the Fed and Treasury deploy extremely stimu­la­tive policies to fight the Covid-19 pandemic.

A few months ago, the Fed announced one of the most significant changes to its monetary policy in recent memory. Chairman Jerome Powell declared that the Fed will change how they target infla­tion. Instead of targeting 2% infla­tion, they will now target an average of 2%. They will allow the infla­tion rate to run hotter before hiking interest rates.

“(The Fed) seeks to achieve infla­tion that averages 2 percent over time, and there­fore judges that, following periods when infla­tion has been running persis­tently below 2 percent, appro­priate monetary policy will likely aim to achieve infla­tion moder­ately above 2 percent for some time.”

 — Federal Reserve State­ment on Longer-Run Goals and Monetary Policy Strategy amended effec­tive August 27, 2020

The Fed may be giving us their playbook here if we read carefully between the lines. They are explic­itly saying that they will allow infla­tion to run hot “for some time” by not raising interest rates or reducing their bond purchases. They will continue to suppress the rates even if infla­tion is high. This keeps the borrowing costs low for the Treasury Depart­ment allowing the spending spree to continue.

This is the WWII playbook, but instead of calling it Yield Curve Control, we see massive bond purchasing programs under a different name yet with the same outcome— the reduc­tion of govern­ment debt as a percentage of GDP through infla­tion. As before, this comes at the expense of savers and bondholders.

The Fed achieves keeping interest rates low through their bond purchasing programs, better known as Quanti­ta­tive Easing (QE). Simply put, the Fed purchases US govern­ment bonds to keep the interest rates low. Since bond prices and interest rates move opposite one another when the Fed buys bonds, bond prices rise, and yields fall.

The Fed continues to purchase $120 billion dollars worth of bonds every month to push bond yields lower. This equates to $834 million dollars worth of bonds purchased every hour for 18 months straight.

The QE programs have accel­er­ated this trend in recent years, with the Fed doing every­thing in its power to keep rates low. As a result of this bond-buying spree, the Fed has now taken interest rates down to the lowest in 5,000 years.

Infla­tion is now at the highest level we’ve seen in decades (CPI remained at 5.4% YoY in July). The Fed continues to suppress interest rates, which are now at the lowest levels in recorded history. Unsurprisingly, we are seeing bond investors bear the brunt of this infla­tion in real terms.

With all this in mind, let’s look at how bonds perform in today’s environment.

Negative-yielding global bonds across the globe are at an all-time record exceeding $18 trillion.

More and more bond investors are paying to lend out their own money and are taking a negative return on their principal when the bond matures. With negative-yielding bonds, they are giving up that principal protec­tion that made bonds an attrac­tive invest­ment in the first place.

The 10-year Treasury real yield, adjusted for infla­tion, is at ‑4.125%, the lowest recorded yield since the early 1980s.

The “risk-free” 10 yr Treasury isn’t looking that risk-free at all. At the current infla­tion rate, the owner of these bonds will lose 20.6% of their purchasing power in 5 years.

Even corpo­rate high yield bonds, the riskiest type of corpo­rate bonds, and there­fore the highest yielding, crossed into negative real terri­tory for the first time in history in July.

Even 85% of the U.S. junk bond market, the riskiest type of corpo­rate bonds, and there­fore the highest yielding, has crossed into negative territory.

From what we recog­nize about the history of highly indebted countries, it appears the Fed is achieving what it planned. They wanted higher infla­tion, and they got it.

When taking into account history, it could be argued that the Fed has an incen­tive to keep its interest rates low in order to liqui­date its debt in real terms.

As Charlie Munger famously said, “Show me the incen­tives, and I will show you the outcome.”

When the Fed is incen­tivized to keep rates low and infla­tion high, we should not be surprised at the outcome we are seeing play out before us.

The question then becomes, “When will the Fed reduce its bond purchasing programs or taper in response to the infla­tion numbers?”

This past Friday at the Jackson Hole Economic Policy Sympo­sium, Fed Chairman Powell hinted that tapering may come as early as the end of 2021 but will continue its bond purchasing program until the appro­priate condi­tions are met.

“We have said that we will continue to hold the target range for the federal funds rate at its current level until the economy reaches condi­tions consis­tent with maximum employ­ment, and infla­tion has reached 2 percent and is on track to moder­ately exceed 2 percent for some time.”

 — Jerome Powell, August 27, 2021

The Fed is making it clear that they won’t be tapering unless they are 100% certain they can do so without causing an imped­i­ment to the economic recovery.

Yet when we look at the Fed’s track record over the last 10 years, every single time they have tried to taper their bond programs, it has resulted in market chaos and a quick return to more QE at the first signs of trouble.

Take a look at the chart below:

This chart shows how every previous taper attempt has led to even more Fed bond purchasing down the road. With debt levels higher today than in the last decade, it is reason­able to conclude that the Fed will have difficulty tapering its QE programs.

Further­more, if they do taper and markets start to fall, the Fed will be quick to restart their bond purchases once again. Thus, we can expect the finan­cial repres­sion of bond investors to continue.

Econo­mist Jim Grant said it best when he described bonds today as “reward-free risk.” If the Fed decides to taper in response to infla­tion, then bond prices will fall as interest rates rise. If bond rates fall to around zero or even go negative, then investors are essen­tially paying to lend their money and/or are receiving little income in the form of interest payments.

If bond rates remain where they are, below the rate of infla­tion, then bondholders will lose purchasing power in real terms. This is the lose-lose-lose situa­tion that bondholders find themselves in today.

So what can be done about it?

In periods of high infla­tion, it is prudent for investors to consider divesting from assets like bonds that lose value in such environ­ments. They are better off instead allocating hard assets that are scarce.

Today, that’s things like real estate, commodi­ties, and Bitcoin. Bitcoin has all the charac­ter­is­tics of an infla­tion hedge, given its fixed supply of 21 million BTC. This hedging charac­ter­istic of Bitcoin is evident when you look at the chart below, which shows a corre­la­tion between Bitcoin’s price and real yields.

As the real yield becomes even more negative, Bitcoin’s price rises. This is a loud signal that Bitcoin could make an excellent addition to a tradi­tional portfolio as an infla­tion hedge.

Bitcoin has returned on average 155% every year, over the last 5 years, well above the current rate of infla­tion. With this return profile, even a small Bitcoin alloca­tion can make a world of differ­ence for a typical bond investor’s portfolio to hedge against inflation.

Bonds need to be viewed through the lens of the world we’re in today, not what they used to be. We find ourselves in an extra­or­di­nary time of histor­i­cally low rates and rapidly rising infla­tion. The fact is that bonds are not as safe today as they are marketed to be.

It’s time bond investors begin to protect themselves against the Fed policies leading to erosion of the real value of their bond holdings. They can do so by divesting a portion of their bond holdings into infla­tionary hedges such as Bitcoin.