Historically low yields point to a bond bubble. What can investors do to improve fixed income? Are products like structured notes or annuities an answer? CEO Tom Quinn shares our thoughts.
Market bubbles present unique opportunities and obstructions for investors. Major bubbles are rare, maybe one per decade. With CornerCap being natural unemotional contrarians, major bubbles are relatively easy to see. The appeal of the bubble comes more from extreme investor behavior than from extremely attractive fundamentals.
Certainly the bond market is a good candidate for the 2010s decade bubble. When interest rates go down, bond prices appreciate. After a multi-decade ratcheting up of rates from the 4% level, bond yields peaked at 15.8% on 9/30/81– as shown in the 10-year US Treasury chart shown below. From then on, rates generally declined for the next 30 years, creating a dramatic bull market for bond investments. For the last five years, rates have hovered in the 2% range. In early July, the U.S. 10-year touched 1.36% and has recently gotten back above 1.5% while rates in several non-U.S. developed countries have gone negative.
When rates go up, bond prices go down, creating a bond bear. The turning point of this bond market bubble cannot be timed, especially given its extreme length. We expect that this low interest rate environment will persist until higher rates are justified by stronger economic activity. However, we are clearly much closer to a bond market peak (low rates) than the bottoming of the market (high rates). When it looks like a bubble and quacks like a bubble, we do not know what else to call it.
No investors are pleased with an under 2% yield with their bond allocation. After management fees and inflation – and seeing little capital gains potential – the net return approaches zero. Most investors have been looking for alternatives. We are also looking for acceptable alternatives, for some time. Several exist, but there are no silver bullets.
The primary purpose for the bond allocation in a portfolio is safety; for capital preservation; for those times like the 2008/2009 crash when equities declined over 50%. How do we manage volatility and downside risk while increasing the total net return for client portfolio’s “safe-allocation”?
For a safe but low returning asset class, the best way to win is to not lose. Assuming that we are in the midst of a long term bond bubble, the opportunity for material losses in this asset class is very real. Interest rates will rise again one day and bond prices will fall. This is why we keep bond durations relatively short and the quality high. We are able to hold the bonds to maturity and avoid realizing any losses, even when rates begin to rise.
As part of our fixed income allocation, for several years we have captured a higher yield by holding passive funds with lower credit quality but that have short-term targeted durations. These funds hold hundreds of higher yielding bonds that have almost all bonds maturing in the same calendar year. By only holding the near-term funds, duration risk is almost eliminated and the below investment grade risk is broadly diversified. We have found that the modest incremental risk is justified for the higher return with our fixed income allocation.
We have also chosen to avoid the traditional rating agencies in assessing corporate credits. Those agencies are paid by the corporations that they rate … sort of like grading your own paper in school. For the bonds that we hold, we use a proven research firm specializing in fixed income for their independent credit analyses. We believe their more objective research identifies rating changes early, and this gives us a price advantage in the bond market. CornerCap pays a reasonable fee for this incremental fixed income return, in addition to better protection from potential torpedoes.
Whenever there is a product being demanded in the market, Wall Street will build and promote attractive alternatives to satisfy that demand. When the products are sold with incentives rather than bought for service, the common thread for the conflict is cleverly concealed downside risks and costs. There are a number of yield-seeking alternative investments currently being promoted.
Structured Notes – Structured notes are becoming increasingly popular. These complex debt securities are created and sold by major investment banks, such as Goldman Sachs, J.P. Morgan, etc. We have found that buyers do not understand and cannot quantify the protections being promoted in the instruments versus the probability of the benefits being realized. The securities are hugely profitable for the seller while camouflaging the risks and costs to the buyer. Below we have charted the risk/return for a typical structured note.
The horizontal scale shows the risk/return expected in the market. The red bell shaped curve reflects the probabilities of that risk/return being realized. The buyer realizes the white area and the seller (e.g. G-S) realizes the gray area. The higher probabilities for occurrence are at the top of the bell curve, offering significant “curbside appeal” for the buyer. But these are relatively low +/- return scenarios, and they can be covered by the higher fees and hedging derivatives. The seller wins with the tails. The buyer is giving up all of the significant upside (right scale) while absorbing all of the significant downside (left scale).
Because of the structured note “guarantees”, they are being sold as a higher yielding substitute for fixed income. They are the opposite of fixed income. Rather than disaster protection for the investor, the investor is providing disaster protection for the seller by absorbing the loss from a potential market crash. And neither is the structured note a growth security since all of the material upside will go to the seller.
Why do so many investors, brokers and advisors think that they are going to win against the house account, i.e. the investment banker who knows the probabilities and writes the contract? Of course investment bankers do lose, like Lehman Brothers in the 2008/09 market crash … which reminds us, structured note buyers are also assuming the counterparty risk. When Lehman folded, many investors had purchased their structured notes from them. These note holders are still in court trying to recover a portion of their capital.
Variable Annuities – While structured notes are more banker-based, variable annuities are insurance-based. And while the features of the securities are very different, the product appeal is the same – for fearful investors seeking downside protections and principal guarantees. Other similarities include the extremely high costs, contract complexity, and lack of transparency. There are situations when an annuity may be the appropriate vehicle for someone, but those occasions are rare and competent counsel that is independent from the commissioned salesperson is critical. Investors who are unwilling to accept modest market risk should expect to pay dearly for their comfort.
We will note a few of the concerns that we have with variable annuities. The total annual costs are generally in the range of 5% to 8%. These costs include the upfront sales commission. This annual cost does not include the surrender fee that must be paid to the insurance company if any withdrawals are made in the first few years. Using the surrender penalty to restrict withdrawals from the funds in those years gives the insurance company the time to recover the selling cost. Other costs include administrative fees, mortality costs and sub-account expense ratios for the managed accounts.
In addition to the above noted surrender fee restrictions, the insurance company’s contractual allowances for annuitizing, withdrawing and passing on the assets are usually complex. We have also noted that many of these tax deferred annuities are purchased in tax deferred IRAs, 401ks and other tax deferred accounts. This doubling-up of the tax deferral offers no tax advantage but it does double-up with the regulatory requirements and restrictions. And similar to IRA-like investments, these variable annuities result in all capital gains being eventually taxed at the higher ordinary income rates (not a capital gains tax rate) and the step-up in the cost basis at death is not available.
High Yield Stocks – Higher yielding stocks, such as utilities and larger consumer non-durables, have performed well recently, realizing a significant price run up. These “never maturing” bond-like stocks are currently richly priced with valuation risks far exceeding the total return opportunity provided by the higher yields, i.e. the earnings growth is not supporting the dividends being paid. In addition to the valuation risk being assumed at this time by these higher yielding stocks, they are also in-fact stocks and not bonds … the downside risk behaves more like an equity.
Bond Quality & Duration – To capture a higher yield in a balanced or bond portfolio, many investors will simply (1) lower the quality of the bonds, e.g. junk bonds, and/or (2) lengthen the maturity of the bonds in the portfolio. The lower quality bonds have liquidity risks and a higher probability of default. As a bond’s quality declines, the bond risk actually approaches that of an equity holding. With non-callable long term bonds, the bond issuer is locking-in the buyer of the bond. In a rising rate environment, significant losses would be realized by the bond holder if not held to maturity. In numerous past periods, long term bonds have actually been more volatile than stocks … the safe allocation should be kept safe.
As value-investors, we tend to get into opportunities early and also out early. As such, we tend to be long gone well before the bubble bursts. Our clients are not immune to bubble behavior, so our early exit from the fun ride can easily disappoint. But by getting out early, we greatly benefitted from the 1979/1980 oil bubble and the 1999/2000 tech bubble. With the 2008/2009 real estate bubble, there was nowhere to hide except cash, so we enjoyed the full ride, crash-to-recovery. So, we have arguably had some success identifying and exiting bubbles.
Given our 40-year philosophy about the fallacy and foolishness of trying to time the market, clients would be surprised with how much research work we do measuring various cycles in the marketplace. What we are looking for are extremes in market prices—whether in the form of a major bubble or a more discrete event.
Our definition of the generic term “market timing” is when hopeful investors shift between long term assets (equities) and short term assets (cash). We believe that this is a money and alpha (risk adjusted return) losing proposition since studies have shown that success is highly unpredictable; there is a cost for these asset shifts; and long term investors typically lower returns by spending too much time in cash, the lowest returning asset class over time. But the reality is that investing is all about some type of timing.
- We select and deselect individual stocks for a portfolio – timing
- We determine when to round up and trim our holdings – timing
- We select sectors and industries to hold and determine their weightings – timing
- We select asset classes to hold and determine their weightings - timing
We also continuously research and work to effectively tilt other equity group characteristics, such as size (large/small), beta (risk-on/risk-off), asset classes (in/out), yields (high/low), etc. With essentially all of these security groupings, a reasonable assumption is that they will move through cycles, as they have for the last century or so. In timing and/or tilting investment decisions, we are always looking for the extremes. We have found that regressing from the extremes of these often overlooked baby bubbles to be safer, value-adding and more dependable than helping the herd to inflate the larger and more obvious bubble.
There are many other alternatives for enhancing a portfolio yield – mortgage REITs, energy MLPs, annuities, etc. We enjoy seeking and assessing higher yielding and total return enhancing alternatives. Of course the purpose of the capital preservation allocation in a portfolio is to always preserve capital. If an alternative clearly increases the downside risk, then do not pretend otherwise. If an alternative also increases costs and lessens transparency, then be alert to the incentivized salesman.
Although not as extreme, the current yield-seeking bubble reminds us of the capital gain-seeking tech bubble in 1999/2000. Investors are pursuing an easily identified segment of the market, and they are not sensitive to fundamental valuations. We can track the movement of the herd; we know where the herd will eventually windup; but we do not know the arrival date. For the tech bubble, the herd hit the wall on March 10, 2000. For the bond bubble, we remain focused on capital preservation and downside risks.