Tuesday, August 31, 2010

Tuesday Q&A Series – Bond Bubble?

We’ve received some great feedback from our readers concerning our special Q&A series that we have been posting on a trial basis every Tuesday for the past three weeks. It seems that people are enjoying the series enough to make it a permanent fixture on the Rollins Financial Blog, so our plan is to continue posting the Q&A series every Tuesday. If you have questions about investing or financial planning, please send them our way at contact@rollinsfinancial.com.

This week’s question comes from Mike, a client who is wondering if bond investments are reaching the “bubble” classification. His concern intensified after reading Jeremy Siegel and Jeremy Schwartz’s August 18th The Wall Street Journal Op-Ed, “The Great American Bond Bubble.” Jeremy Siegel is a distinguished Professor of Finance at the Wharton School of the University of Pennsylvania and is known as the “Wizard of Wharton.” He is also a senior adviser to WisdomTree, Inc., where Jeremy Schwartz is the director of research. Both of their opinions carry great weight in the investing world.

Q. When reviewing my investment accounts managed by Rollins Financial, I’ve noticed that you’ve moved somewhat away from stock-based mutual funds into bond-based mutual funds. I am concerned about moving into the bond arena when it’s been said that there is already a bond bubble. In the long run, wouldn’t we be better off buying stocks than investing in the current bond market?

There’s been a lot of discussion in the financial press regarding a bond bubble. The Siegel/Schwartz WSJ Op-Ed poses a great argument that those who are rushing to invest in the bond market are perhaps doing so at the wrong time. Siegel and Schwartz make a convincing and credible argument that investors should really be buying stocks right now since they are so cheap instead of bonds, which are outrageously expensive in comparison. Some background information on the topic is appropriate to make sure everyone understands how extreme things have become in the U.S. stock and bond markets.

Due to the uncertainty of the equity markets and the basic distrust of the economic recovery in the United States and the rest of the world, investors have been rushing to purchase U.S. Treasury bonds and notes. From January of 2008 through June of 2010, over $230 billion has been removed from stock-based mutual funds. Over the same timeframe, there has been $559 billion of inflows into various types of bond funds.

Based on the theory of supply and demand, the demand has overwhelmed even the massive issuance of bonds due to the federal deficit and has forced interest rates down. In addition to the public and foreign governments acquiring U.S. government debt, our own Federal Reserve System has been a net purchaser of bonds of all kinds and now holds on its balance sheet close to $2 trillion in residential real estate bonds and, to a lesser extent, U.S. Treasury bonds.

Predictably, the purchase of these bonds has forced down interest rates to historic lows. The 10-year Treasury bond today is now yielding 2.5% for the 10-year period. An investor would definitely have to be somewhat cynical regarding the U.S. recovery to accept a 10-year rate to maturity of only 2.5%. One-half of the stocks in the Dow Jones Industrial Average have dividend percentages greater than 2.5%. Even in the most recently down-rated GDP for the 2nd quarter of 2010, the growth rate in the U.S. was 1.6%.

If you assume that the growth rate normalizes in 2011 at 2.5% and inflation meets its assumed target of 2%, then you would be willing to accept a real rate of return over a 10-year period at an amount barely above zero purchasing power. This is calculated by the rate of return on your investment at 2.5% less 2% inflation for a marginal return of .5% for the 10-year period.

Treasury Inflation-Protected Securities (TIPS) is a category of 10-year U.S. Treasury bonds that automatically adjusts for inflation each year. At the current time, bonds are selling for a negative rate of return given that the current rate of inflation exceeds their coupon rate. In fact, these bonds are currently selling at 100 times their estimated payout, which ironically mirrors the high-flying tech stocks in 1999 just before the 80% market correction of those same stocks. The last time U.S. Treasury bonds sold at such low rates was in 1955 when President Eisenhower was in office and the U.S. was suffering from the slowdown from World War II with almost a zero growth rate and a zero inflation rate.

Although pessimism regarding the U.S. economy seems to be running rampant, I do not agree with that sentiment, and therefore, I am not willing to accept such low rates of return. It was only last spring that a 10-year Treasury bond had a yield of over 4%; today those rates are close to 2.5%. If U.S. Treasury bonds were to return to the 4% range, investors who purchased them at 2.5% would receive a loss of principal in the double-digit range.

If Siegel and Schwartz are correct, then why is Rollins Financial investing in bond funds? First and foremost, it’s important to understand that there are many different types of bond funds. We rarely invest in bond funds that are dominated by U.S. Treasuries. In short, I concur with Siegel and Schwartz that stocks are extraordinarily cheap and will almost assuredly go up while investing in U.S. government bonds is a losing proposition. After all, interest rates will assuredly be increasing in coming years, bond investments will pay a lower interest rate, and there’s the enormous potential for capital depreciation.

At Rollins Financial, we very rarely invest in mutual funds that are exclusively comprised of U.S. Treasury bonds. While we find U.S. Treasury bonds vastly overvalued at the current time, U.S. corporate bonds are actually much more fairly valued. In fact, in spite of the deteriorating state of the U.S. government, the finances of U.S. corporations are improving almost daily.

For example, we have invested in the five-star PIMCO Investment Grade Corporate Bond Fund for several client portfolios. Of this entire $5 billion bond fund, only 5% is invested in U.S. government instruments while almost all of the remaining assets are invested in high-grade corporate debt instruments. This PIMCO fund has over 703 individual assets, of which 55% are in corporate bonds with an “A” or better rating.

Additionally, with corporate profitability at its highest point ever in corporate America, defaults on these types of bonds are virtually nonexistent. At the current time, the yield on this PIMCO corporate bond fund is at 5.5%, which is over twice the rate that can be earned on a 10-year government guaranteed instrument. We believe these types of bond funds offer the opportunity for stable current income and capital appreciation while the stock market continues to trade in a sharp trading pattern, basically swinging one way or the other significantly. This type of fund offers a nice diversification away from volatile stock market funds.

This bond fund adds significant stability to our portfolios; it even earned a profit in 2008 when both stock and bond funds took severe losses of principal. The fund’s upside potential is noteworthy in that it had a return of over 18% in 2009 and did not lose money in the period from 2003 through 2009. While the PIMCO Investment Grade Corporate Bond Fund constitutes a bond fund, it is clearly not the same type of bond fund investment that Siegel and Schwartz criticized in their Op-Ed piece.

Another type of bond fund of interest to us at Rollins Financial is the PIMCO Emerging Markets Bond Fund. As in the PIMCO Investment Grade Corporate Bond Fund, this bond fund carries a 5-star rating by Morningstar. It is an excellent fund that is comprised of some of the sovereign debt of the Emerging Markets (i.e., Brazil, Mexico, and Russia).

In addition to the two excellent bond funds mentioned above, we also invest in a series of high-yield bond funds. About ten years ago, these types of funds were called “junk bond funds.” In those days, they were viewed by many to have very low quality bonds, and correspondingly, the default rate on these bonds was fairly high. In recent years, however, due to the banking problems, many corporations in America are using these types of debt instruments to finance their businesses. In most cases, the yields on these investments are over 7%, which is many times the interest rate an investor can earn on government guaranteed debt.

Given the extraordinary profitability of U.S. corporations at the current time, we believe these bond fund investments are appropriate. Since the debt has a higher credit rating than the equity of these companies, the defaults are very low and their earnings are high in respect to other types of interest earning investments. That said, we do not plan to keep these bond fund investments in our client portfolios forever.

We still believe that stocks are currently incredibly undervalued and will offer an excellent opportunity for profits for years to come. When an investor can buy stock in excellent companies like AT&T and Verizon with dividend yields in excess of 6% and blue-chip stocks like Exxon Mobil, Chevron, Procter & Gamble and Johnson & Johnson at over 4%, these high rates of dividend returns signal a bottom for stock prices in the future.

In summary, due to the extraordinary U.S. stock market volatility we have endured over the last eight months, we think it is appropriate to take advantage of bond funds to at least earn our clients some interest during this time period. These bond funds add diversification and stability to a portfolio; in this market, both are good attributes to making more money for our clients. You may rest assured, however, that as the U.S. stock market stabilizes, we intend to move some of our clients’ assets from these bond funds back into equities where we believe there is greater potential for more substantial gains.

Thanks for the excellent question, Mike. I hope you and our other readers have a better understanding of the types of bond investments that Rollins Financial finds to be appropriate for some of our clients.

In next Tuesday’s Q&A post, we’ll be answering Gus’s questions regarding international investing. Gus is particularly interested in learning more about China’s role in the global economy and how it affects U.S. investors.

As always, we hope our readers will keep Rollins Financial in mind when seeking professional investing and financial planning advice, and of course, there is no greater compliment than the referral of a friend or family member.

Best regards,
Joe Rollins

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