Government bond market bubble? Wall Street Journal op ed column says Yes

frozen by CNBC

I had turned off my computer late yesterday morning and gotten ready to leave, when I decided I wanted to see how stock trading on Wall Street was progressing.  Rather than wait for my pc to boot up again, I turned the tv on to that financial reality show cum soap opera, CNBC.

Yes, there was the usual cast of buffoonish men and smart women.  They were making lots of inane comments in loud voices, trying at one and the same time to inject meaning and excitement into the random moment-to-moment movement of securities prices as well as to disguise their fundamental lack of knowledge/experience in the markets themselves.

Instead of simply looking at the market data and turning the tv off, I found myself listening with more than one ear to a “debate” about an op-ed column in that day’s Wall Street Journal, titled “The Great American Bond Bubble.”

“Artful’ is probably the word I’d use to describe the proceedings.  A CNBC talking head rambled passionately but incoherently.  Nevertheless, he was framed on the screen in the same group as the third-party bond experts appearing on the show, visually suggesting to the viewer that the Wall Street veterans endorsed his credentials.

One of the guests, a bond strategist from Pimco, said that the fact that the yield on the 5-year Treasury being 1.43% did not mean that bond prices were high.  How so?  …because the 2-year note yields .49% and the 10-year bond 2.63%.  Huh?  The fact that the yields on Treasuries of different maturities are internally consistent with one another says nothing about whether they’re cheap or expensive.   So what this guy said was possible true, but had no bearing on the point.

Another guest strategist–again avoiding the point–said it was outrageous for the op ed authors, UPenn professor Jeremy Siegel and his coworker at WisdomTree fund management, to recommend that investors sell all their Treasuries and buy stocks.

Think what you may about CNBC’s stock market expertise, the channel certainly hasn’t gotten where it is today by focussing on topics investors aren’t interested in.  So though I rarely read the WSJ any more, I thought I’d take a look at the op ed column.

“The Great American Bond Bubble”

The column makes a number of points:

1.  Nominal yields on Treasury bonds are extremely low.

2.  Yields on some inflation-adjusted Treasuries are negative in real terms.

3.  For taxable investors, after-tax returns are even less attractive.

4.  Despite this, investors continue to pour money into bond funds, a state of affairs the authors liken to the Internet stock mania of 1999.

5.  The justification for doing so is that “purveyors of pessimism” (read:  bond fund management companies) assert there are long-lasting “fierce headwinds against any economic recovery”–which the authors compare with the extreme optimism of Internet buffs a decade ago.

6.  Current securities prices–both stocks and bonds–are already discounting the worst possible outcome.  (I may not be doing justice to their argument, but I think this is it.  In fact, what I’m writing may be an improvement on what they say.)  Either the economic situation turns out to be as bad as the pessimists say (think: “new normal”), in which case securities prices don’t move very much; or at the first suggestion that we’ve passed the worst of the crisis bonds fall and stocks rise.

Therefore, “Those who are now crowding into bonds and bond funds are courting disaster.”

7. For income-oriented investors,  “value” stocks, that is, ones with low pe ratios and high dividend yields, are a much better bet.

my thoughts

First of all, it’s important to note that Mssrs. Siegel and Schwartz are both tied to WisdomTree, a fund management company founded by retired hedge fund manager, Michael Steinhardt.  No prizes for guessing what WisdomTree specializes in.  That’s right, value stock and dividend-oriented equity mutual funds and ETFs.  In a feat of linguistic legerdemain, WisdomTree calls its products “index” funds, even though the funds’ contents are selected/weighted according to decision rules devised by Mr. Siegel.  But that’s another story.

Similarly, as I’ve been writing about for some time, bond fund management companies have a similar vested interest in all world economies being pretty awful for an extended period.  It seems to me that this is the only scenario in which bonds, especially government bonds, won’t lose money.  The minute the US economy starts to get back on its feet, the Fed will withdraw the emergency monetary stimulus it is presently supplying and interest rates will rise–sending bond prices falling.  It’s not clear this will be an orderly process, either.

Myself, I think the op ed article makes a good point.  I’m not sure I’d endorse the entire top ten list that Professor Siegel provides.  He is a professor, after all, and not an investor.  I’d prefer companies that don’t have a history of cutting the dividend, as GE did during the financial crisis.  And much of VZN’s cash flow is contained in Verizon Wireless, its contentious joint venture with Vodafone, and therefore not readily available to distribute to VZN shareholders.  I’d also place more emphasis on firms that have been raising the dividend steadily, even if that means accepting a current yield of less than the 4% Mssrs. Siegel and Schwartz cite as average for the names they mention.  So I’d consider INTC, with a 3.2% current payout, or WMT at 2.4%.

There is one big feature that separates bonds from income stocks.  Bonds have a fixed maturity.  If you buy a 5-year Treasury for $1000, then when it matures in 2015 you’ll receive your $1000 back in full.  Not so with stocks.  Their value five years hence could be higher or lower, depending on market conditions.  Just look at the price of any US stock today and compare it with the quote in March 2009 for what is essentially the same economic entity and you’ll see what can happen.

Of course, one might observe that stocks rebounded quickly from this very low level–the yield on the entire stock market was higher than the 10-year bond yield then–and that the last previous instance of such a low was over thirty-five years earlier, in late 1974.  But neither point has made any difference to US investors.

One point is important to realize, however.  The  get-your-principal-back feature applies only to holders of individual bonds, not to holders of bond funds.  The latter are collections of bonds of varying maturities that don’t have a common due date.  So when you redeem your bond fund you have no assurance that you will recover your principal.  If you want your money from a bond fund during a period when the Fed is raising rates, I think there’s little chance of that favorable outcome happening.

For what it’s worth, stocks are subject to two opposing forces during a period of rising rates.  As financial instruments, better returns on a competing instrument (cash) means downward pressure on prices.  On the other hand, the Fed will only raise short-term interest rates if the economy s in good health and corporate profits are rising.  Profit gains tend to push stock prices up.  In the past, stocks have typically made gains during tug-of-war periods like this.

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