Why I’m Buying Bonds

2022 has seen one of the worst crashes in bond funds ever and it's interesting that when that happens to equity people say you should buy it because it's a bargain but you never hear that about bonds so in this video we're going to look at two reasons why now might be a good time to buy bonds and two reasons why it might not be and also i'll talk about what i'm doing in my own fund portfolio so let's look at the bond crash and whether it's now time to buy bonds in a bit more detail let's begin with the reasons for and against buying bonds starting with the reasons for buying bonds i think the first one is that we might get a us recession normally that's a good environment in which to buy bonds remember bonds feed on economic misery whereas equity feeds on economic joy so if there is a recession that's usually good for bonds the second reason is that yields are now higher so if you buy into a bond fund your expected return will be much higher than it was just six months or a year ago and if we look at the reasons against buying bonds now the kryptonite for bonds is inflation and if inflation stays high for a long period of time that would be an awful story for buying bonds because it erodes their value over time and just as recession is good for bonds if growth surprised on the upside well in that case that would be bad for bombs so maybe things aren't as bad as we thought for the u.s economy now let's look at the atrocious losses in bond funds in 2022 in this top panel what i've shown is the u.s one-year treasury yield and the 30-year treasury yield since 2019 and you can see the broad pattern is that they start off fairly high they fall very sharply in 2020 with the pandemic and then gradually in 2022 and then very quickly yields have risen again now of course the relationship between yields and prices for bonds and bond funds is an inverse one so that when yields fall prices rise and when yields rise price is full and in this bottom panel what you can see are the prices of three of the largest u.s etfs for u.s treasuries now what i've done is i've got three different durations for those funds so shy is the black line above me that's the one that doesn't move up or down much because it's very short duration funds that just buys treasuries which are in the one to three year maturity range and those are very insensitive to yield curve movements that's why in 2020 that shy fund only increased very slightly in value ief is kind of the belly of the curve that's the seven to ten year range of maturities and you can see the price of that fund increased a lot more than it did for shy in 2020 and then finally in red we've got the really long duration u.s treasury fund which is tlt and that only buys u.s treasuries which mature in 20 years or more so this is really long duration it's very sensitive to interest rate movements which is great when yields are moving down because the price moves up a lot as it did in 2020 however in 2022 what you can see is everything went into reverse so the longest duration treasury fund tlt has lost huge amounts of money and shy has lost least with ief somewhere between the two now the other important thing to point out is if you look at the black line here the short end of the us treasury curve that pretty much tracks what the federal reserve sets as its monetary policy rate that's the federal funds rate so when the fed raises interest rates or sometimes a bit before this one year yield will start to rise and it rises pretty much to be in line with that federal funds rate whereas for the longer end of the curve for the 20 or 30 year part of the curve that's driven much more by growth expectations that's gdp growth but also inflation expectations so for example in 2020 when the fed cut interest rates to zero the one-year treasury rate pretty much tracked it whereas the 30-year fell because growth expectations fell inflation also fell but it fell nowhere near as much as the one-year rate and then as growth expectations gradually improved so did the 30-year yield and a big part of the yield increases we've seen at the 30-year part of the curve in 2022 are due to inflation rising if we break down the returns on shy ief and tlt into year on year returns and that goes back to 2005 you can see shy here in the top panel and that really doesn't move around much at all that's only lost minus 3.4 percent in 2022 so far whereas ief has lost about 12 and tlt has lost a whopping 24 so far in 2022 now that's not the biggest fall it's ever had in 2009 as yields started to rise after the global financial crisis it lost about 25 but still a very big loss for tlt this year now using robert schiller's data we can push back the analysis further and this takes us back to 1953. again we'll look at annual u.s 10-year treasury returns which is roughly equivalent to the ief fund which is the intermediate fund that we saw previously so as of march 2022 which is when i got the last update from schiller's spreadsheet tenure treasuries had lost 20 percent now that is in fact the biggest total real return loss for us year treasuries since 1953. now to put that into some kind of context in the bottom panel here you can see the total real return for the s p 500 in the same periods so a really big loss for equity which is about 40 percent or maybe 34 percent is usually much bigger than it would be for bonds so this 20 loss is truly catastrophic for a bond fund and really it's been a perfect storm for u.s treasuries because growth expectations have picked up but also inflation is extremely high and that's what you can see on this graph and in 2022 if we go back to a previous time when inflation was this high we have to go back decades and we're just looking at the really high inflation period this kind of double peak in inflation in the mid 1970s and the late 1970s and early 80s now this is the kryptonite for bonds because if you're receiving a fixed rate of income then any kind of inflation which is higher than that income will effectively erode any value or any income which you're getting with that bond so certainly one of the reasons why we had such a huge sell-off in bonds was because of this very high inflation before we move on to the reasons for and against holding bonds right now many of these relationships are the type of thing i discuss all the time in my free weekly market roundup it's a great way to learn about those relationships and there's always a funny tweet usually about a dog at the end of the email if you want to learn more about that just click on the link beside me and in the description beneath me the first reason for buying bonds is that we might be about to enter a u.s recession in this top panel you can see u.s cpi inflation and the blue shaded regions are u.s recessions now remember that inflation is bad for bonds so when it falls that's good for bonds and notice that during a recession it usually marks the point at which inflation falls from a peak it happened in 1970 you can see this turning point again and this was around 1974 then there was another turning point in 1980 again marked by a recession and then this strongly disinflationary period that's when the rate of inflation is falling was again a u.s recession it really is a very consistent pattern even if inflation starts off very high initially and then in this bottom panel you can see the price of oil now remember that when its price fell almost a zero in the futures market in 2020 again that was because of a very sharp recession similarly in 2009 this very rapid fall in the price of oil was due to a u.s recession and you can see again that this is a fairly consistent pattern and the reason for that is that the us is a big user of oil it has a very large demand for oil so when u.s economic activity falls which is what a recession is the demand for oil falls and usually the price will also fall now at the moment there's a big imbalance between supply and demand for oil because after the lockdowns that we saw during the pandemic economic activities restarted the demand for oil has increased and yet at the same time the supply has fallen so that's been very inflationary for oil prices and energy prices in particular but if we do see a u.s recession then what we'd expect to see is demand for oil would probably fall and that would drive down energy prices and that's also a big driver of u.s inflation so if inflation did come down that would be good news for u.s bonds and what we'd see is that bond yields would fall and bond fund prices would rise and the funds which would gain the most would be those with the greatest duration like tlt the second reason for buying bonds now is that yields are higher now roughly speaking the yield on a bond or a bond fund is roughly the income you receive both from the coupons on the bond but also due to the capital gain on the fund now what we can do is look at something called the yield curve so what we plot here is the yield on bonds of different maturities so here we've got one year us treasuries all the way up to 30 aus treasuries and this is a snapshot about a year ago on june the 23rd notice how the short end of the curve is very low the long end of the curve is relatively high so what we've got is a pretty steep yield curve but whatever the maturity of the us treasury yields were pretty low across the whole curve compare that with what we've got as i make this video and we've got a pretty flat yield curve and the yields are all higher so even at the short end of the curve the yields are now above three percent that's a very different macro world from the one we found ourselves in just six months or even a year ago effectively what that means is that you get a bigger income with your bond funds right now and gradually as time passes and the contents of the fund mature and then get replaced they'll be replaced with bonds which have a higher income a higher coupon so the risk reward that you get with u.s treasuries pretty much of any maturity right now is much better than it was just a few months ago there's also more leeway for bond yields to fall because previously you can see at the shorter end of the curve in particular there wasn't much room for falls and some people thought that would constrain the upside on bonds the situation now is that bond yields have much further to fall so that means there's more upside for the price of the funds now let's look at the reasons why you might not want to have bonds and the first one is sticky inflation what do we mean by that well if you look at the components of the cpi basket this is how the cpi inflation is measured by looking at a broad basket of goods and services which us consumers buy regularly you can actually decompose it into two groups now some of those items have their prices updated regularly so those are called flexible price items in this research note from 2010 but some other components actually have a high relative importance but their prices are infrequently updated so for example toddler's apparel has its prices updated very infrequently as do household furnishings and operations whereas motor fuel has its price updated very frequently and the same is true of the price for fresh fruits and vegetables so what we're going to focus on are the components of the cpi basket which are more predictive of future prices because if those components are rising we'd expect inflation to stay higher for longer well here's the cpi rate of inflation going back to before 1969 just focusing on those sticky components now notice what's happened recently in 2021 and 2022 is that that sticky price inflation has soared upwards it's still not as high as it was in the early 1980s but it's still increasing rapidly and in fact the fed noticed in its june meeting that price pressures have spread to a broad range of goods and services it's not just about fuel now it's also spread to the price of services so if that's the case inflation could stay higher for much longer than we expect and that would be a terrible story for bonds because remember they hate high inflation the second reason why it might not be a good time to buy bonds is that we might get a u.s growth surprise remember at the beginning of the video we said that the long end of the yield curve was driven by growth expectations so what i've actually plotted here is u.s nominal gdp growth that's not adjusted for inflation and i've compared it with nominal treasury yields so gdp growth is in blue and the 20-year yield is in red and you can see they track each other reasonably well and this shows data going back to the early 1960s so for example as u.s nominal gdp growth was increasing so did yields on u.s 20-year treasuries and as gdp growth started to tail off so did the yield on treasuries so what would happen if growth isn't as bad as people expect everyone's talking about a recession in the united states but what if that doesn't happen what if growth is actually reasonably good well that would be a really bare case for u.s treasuries particularly long dated ones if growth was higher than expected then u.s yields would rise and bond prices and bond fund prices would fall so that would be the bear case for bond funds now what you can actually do is to back out what the fair yield would be on us treasuries given a level of gdp growth so that's what i've done here i had to smooth us gdp over a five year period i took the rolling five-year median and once you do that and build the model the fair yield that you get for us treasuries at the 20-year part of the curve is 3.4 percent which is very similar to the current yield which is 3.5 percent so if growth did surprise to the upside then yields would rise prices would fall and it would be a bad story for us treasuries so what am i doing about that right now firstly i should stress that this is in my fund portfolio which is a very small percentage of my total capital and this is where i do all the kind of tactical trades which usually lose money really the sole purpose of that portfolio is just to keep my hands off the core where i just have three funds global equity and global bonds and in that core portfolio i've simply carried on drip feeding into globally diversified equity but for the fund portfolio i do the tactical stuff which often loses money and this trade would be no different now one of my big success stories in that portfolio was my commodity fund so just as the commodity super cycle story was kicking off after we came out of the pandemic i bought into this diversified commodity fund and that fund has risen by about 70 percent so this was a rare case when i actually made money in my fund portfolio well i finally sold that fund and the reason for that is that if we do get a u.s weak period of growth or even a recession that's going to reduce demand for commodities and it'll be bad news for that fund and in its place what i'm thinking of doing is buying us treasuries i'm not sure which duration to choose at the moment but i think that's going to be its replacement and the reasons for that trade are the ones i've listed in this video in conclusion then if we do get a u.s recession or a period of very weak growth that could be a very good story for u.s treasuries and the reason for that is that if oil prices fall due to reduced demand then we'd likely also see inflation falling because energy prices have been a big driver of u.s inflation and lower inflation would mean that u.s yields would actually fall as well and prices would rise the bear case for u.s treasuries is that inflation might be more sticky than we expect if inflation really is spreading out to other components particularly services and those sticky components then it might be around for a long time and that's a really awful situation for u.s treasuries or it might be that people are simply too pessimistic about u.s growth we might be about to see a resurgence in growth in which case again that would be awful for u.s treasuries because yields would rise at the long end of the curve and bond fund prices would fall now if you do see any kind of price crash if you're a contrarian you're tempted to rush in and buy the asset because it looks like a bargain but in the case of us treasuries i think there are these fundamental reasons why yields might be too high at the moment perhaps people are just too optimistic about u.s growth and if we do see a us recession that would be a great case for buying us treasuries inflation is a problem and if that does stay high for a long period of time that is a bear case but i think that if there was a recession then probably that would be hugely disinflationary so we'd expect to see inflation come down too and remember that's what the fed's trying to do which is reduce demand and push inflation down so i think there are many reasons why this is looking attractive right now but as i say this is my fund portfolio don't copy me and if you are going to do it only to use a tiny bit of capital to do so remember we've got our offer for our free weekly market roundup if you want to learn more about that and learn about macro and markets just click on the link beside me and in the description beneath me and as always thank you for listening

Channel: PensionCraft

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Keywords: bond crash, bond crash 2022, bond funds, bonds, bonds explained, bonds for beginners, bonds vs stocks, buying bonds, government bonds, investing, investing in bonds, investing in treasury bonds, pension craft, pensioncraft, pensioncraft bonds, portfolio, stock market, why invest in bonds, are bonds a good investment

Id: bLsEOsXd-K4

Length: 18min 59sec (1139 seconds)

Published: Sat Jul 02 2022