Bonds in Turmoil

Steve and Clem examine how bonds have shifted from reliable safe havens to potentially risky investments in today's economic landscape, challenging conventional wisdom about treasuries as risk-free assets.

• Bonds traditionally provided safety and income, but inflation and economic uncertainty have changed this dynamic
• Bond vigilantes reacting to tariff announcements revealed hidden vulnerabilities in bond portfolios
• Long-duration treasuries (20-30 years) make little sense for individual investors despite their institutional utility
• Corporate bonds from companies with strong balance sheets may offer better safety than government treasuries
• Municipal bonds provide tax advantages and allow investors to leverage local knowledge
• Current inflation concerns suggest shorter bond durations (2-3 years vs. market average of 6 years)
• "All that is riskless is not US Treasuries" – questioning the fundamental assumption of risk-free government debt
• Rising rates can significantly impact bond values through duration risk (5-year duration means ~5% loss per 1% rate increase)

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Chapters

• 0:50 Welcome to Skeptic's Guide to Investing
• 2:02 Bond Safety in Today's Economy
• 6:33 Bond Vigilantes and Tariff Effects
• 10:24 Corporate Bonds vs. US Treasuries
• 14:40 Duration Risk and Investment Strategy
• 21:39 Closing Thoughts on Bond Safety

Transcript

Clem Miller: 0:26

Hello everybody and welcome to Skeptic's Guide to Investing. I'm Clem Miller and I'm here today with Steve Davenport and we're going to talk about bonds today and the role of bonds in the current environment and some of the interesting things that happened with bonds during the recent turmoil over tariffs. I know I had a brief foray into bonds, which I regret. After the turmoil. Thankfully, I didn't put too much into bonds. I felt it was at least you know, a little bit experimental on my part and I quickly, quickly got out of it. But, steve, you're really the bond expert among the two of us. Thoughts about what's going on right now with bonds, especially in connection with this unusual macro environment that we're dealing with.

Steve Davenport: 1:38

I don't know. Just like our gold discussion I think that this one has a lot of heroin and I look at what's going on with the debt ceiling, I look at what's going on with the budget and extension of the tax cuts and I look at what's going on with the reputation around the world, and I think that it's probably been there have been few times where it's getting less and less clear that treasuries as a home of safety are necessarily the best place for you. I look at the owning of bonds and I think it's a good way to have some income and some safety assets so that when your risky assets go down, you can turn to that safety asset that's probably gone up while the other's gone down and you can take that and then buy the market at a lower level. I think it's good to have alternatives and to have that form of safety. When I think about safety, I think about each individual has in their lives a certain amount of money that they're going to need in the next 6, 9, 12 months that they don't want to see fluctuate every day, and so in that sense, the question is be in cash or be in bonds? David Schawel, md, phd. And I think that, with rates now in the 4% to 7% depending on how much risk you take on for corporates and high yield I think there is risk you take on for corporates and high yield I think there is a reason to be owning bonds. I think there is always a reason, but it's particularly compelling now.

Steve Davenport: 3:18

Two or three years ago, when we were talking about zero rates or near zero rates, and mortgage rates were two and a half, I thought that we did a disservice to the industry by not telling people that bonds weren't for you. We didn't tell people to get out of them. Instead, we let people get eaten up by inflation and really, when you think about it, that's the main driver. Right, inflation, plus any appreciation associated with a particular currency could be a good reason to own bonds, but I think it's highly likely that we're going to see inflation go back up into the threes and perhaps four percent level, which will make bonds need to pay you more in order to be worthwhile. And that's really where I think this whole, the whole area of bonds, I think, has to start with the Fed, because the Fed determines the short-term rate and then, as we go out and we get paid a risk premium for a longer duration, then we see higher rates for the longer term.

Steve Davenport: 4:37

We've had this inversion going on for years now and I think that the short rates have been higher, long rates have been lower and I think it's been a very difficult time for the average investor. The average investor says I want safety, and by safety they mean something that doesn't go down. I don't think bonds have been that for us in the last two, three, five years. I think the bonds have been an asset that traditionally has performed very well.

Steve Davenport: 5:09

But I think that we've got to ask the question is are the bond vigilantes, who many people believe could be stronger at analyzing risk and returns than some of the equity analysts, realize that the way the US is running is being run, the way that international companies and international countries are looking at their relationship to the US and how much they want to have in treasuries and how much they want to have in wands and or, you know, different euros? I think that people are starting to say maybe the US is a place I want to have some of our assets, but I don't want to have all of them there. I think I want to hedge myself and own some euros.

Clem Miller: 5:58

So Steve, can you explain to everybody what a who, a bond vigilante is like, what is a bond vigilante? And also can you explain a little bit about what happened right after the tariffs? Like, what were the bond vigilantes doing that resulted in bonds seeing some losses right after the tariffs? I mean, shouldn't we seeing some losses right after the tariffs? I mean shouldn't we, when everybody expected bonds to do better than stocks, coming out of the tariffs, why did bonds not do well?

Steve Davenport: 6:35

Well, I think that what you don't want to have is bonds back up on you. So if rates, if you buy a bond and it's a 4% and it's got a five-year duration, then you expect that if rates fall which is what Trump has been calling for Powell to reduce rates. And some people believe that a lot of this activity on tariffs and all of this upheaval is really about causing a slowdown in the US so that the Fed would lower rates. And if the Fed lowered rates, then your portfolio owning a five-year duration 4% bond, you would earn some capital gains on that. So bond vigilantes are saying I don't see this as a slowdown, I see this as a major inflationary event. And then rates go up. So if rates go from 4% to 5%, that 1% move on a five-duration asset is going to cause a 5% decline. And so when you look at that and you say, hey, I just lost 5%, my bond coupon is only four annually Now I'm underwater and I haven't even received my coupons yet. And so I think that what everybody is starting to realize and why Trump had to put a hold on the whole idea of this 90-day period of grace period was because he was worried that the financial system was starting to implode and he says I can handle a recession, but I can't handle a financial blow-off. And I think that that blow-up was starting to occur.

Steve Davenport: 8:21

And I think that when you look at certain bonds high-yield bonds that are on the borderline they started to drop into that default risk category, and when there is default risk, there is going to be somebody who has to pay the price, and they bought these bonds to get a little bit extra yield. So if you took extra risk and had a 6% high yield bond, all of a sudden, when that bond market starts to back up, your duration can be pretty long and your risk can be pretty high. So that's where people have gone to hide. And what I would say is, if we follow some of the Buffett analogies here, you need to wait until the tide goes out to see who has their bathing suits on. And I think that what we're seeing is that some people have taken more risk in the bond market and therefore they're not really prepared for an upheaval in their bonds.

Steve Davenport: 9:23

Most people look at bonds safety. I think there are people who are like I want my safety, but I want just a little bit more, and that's where people get into trouble. That's where they say I'm reaching for an extra one or one and a half percent and guess what, when I reach for it, do I get it for free? There is no free lunch. So if you are taking on and getting more risk and getting more yield, therefore when there is an upheaval you're going to see more impact to your returns. It's not the same amount as in equities. Yes, the correlation is slightly negative, but what we've seen lately is, yes, bonds do go down and when rates are moving up, which I think that, do you believe, like I do, that tariffs are inflationary? Yes, so if we believe that-.

Clem Miller: 10:22

I think they're stagflationary. They're going to result in some decline in US growth. Plus, they're going to increase inflation in certain areas and probably overall.

Steve Davenport: 10:40

So I think if we look at the marketplace and we say this asset has been a place that has rewarded long-term investors as a safety depository, I think that when you look at it as a place for safety, then we have to ask ourselves tougher questions about what is the best balance sheet to be associated with.

Steve Davenport: 11:04

And what I've been doing recently is looking at more and more corporates, because if I look at the balance sheet of a Microsoft, I look at the balance sheet of a J&J, a Merck, I look at theirs and say, gee, there's a lot less debt here than there is in the US. The US government has now started to be in a place where and we're going to get into this next week with our guest Steve Gattuso we're going to start to look at what is the amount of debt that the US has, that it becomes a problem. I know that we can print currency and produce and pay off, but that again is inflationary. And now that we've seen inflation and how it can affect bond portfolios, I'm not sure we're ready as a country to go back to times like the 70s where inflation was a bigger problem. And once you have inflation, it's not that easy to put it back in the bottle, and so I'm afraid that the area of bonds needs to be rethought and I think we need to rethink why we own them, for what period of time and then what duration I think the other and credit risk and credit risk. The other is credit risk, which I was just going to mention munis.

Steve Davenport: 12:29

Munis are a bond that is tax-free at the federal and the state level. So if you are in Massachusetts and you buy a Massachusetts municipal bond, you are free from the state and the federal level for paying taxes on that income. So while it may only pay you three and a half to four because it's all tax-free, that's the equivalent yield of six if you're at a 30% tax rate. What does that mean? That means lots of people who just don't want to impact have the government standing over them asking them every year at April 15th how much have you paid me?

Steve Davenport: 13:13

I think that when we look at bonds, we look for safety and we look for things we can believe it. I think that local you know local ownership of munis is a good way for individuals to understand. I see this road, I see the tolls being collected. I see this airport. I always know it's well run and it looks great and it looks to be in good condition. Therefore, those municipality generated assets you know can be a very good source for you to put your money into something that you have some control and local knowledge of.

Steve Davenport: 13:54

Should you be picking individual bonds? Probably not, but they are there and they are an asset and I think that when we look at it muni bonds, mortgages, different types of private debt there is a lot there and we could go into that on a different podcast. But I think what I would say is treasuries are not the king. The king has lost some of his luster and therefore I think we need to be a little more sensitive and try to realize that they're not non-negative returning assets. They do go down and when they go down, when the payments are low especially when we were down in the 2% range, you know a 3% or 4% decline in the bond means you know that's two years worth of interest. So I think that you know you can't afford. When you have stocks paying, you know our dividend paying stock portfolio is paying three and a half, is it? You know the four from treasuries? No, it's taxed a little bit better, but it has appreciation potential and it has income.

Steve Davenport: 15:14

And so right now I'd say, depending on your position and how much you need the income in your portfolio, I think you want to look at bonds a little more carefully and potentially be a little shorter.

Steve Davenport: 15:25

So the average duration of the US market, the aggregate bond fund, is about six.

Steve Davenport: 15:32

Six years duration means if you take the coupons and you add up all the coupons and then the final $1,000 at the end that you should get paid when you hand over your bond, it adds up to a cash flow of about six years in duration and I think that for most people we should probably be in the two to three-year duration right now because we don't know particularly whether we're going up or down.

Steve Davenport: 16:02

We don't know the impact of tariffs, we don't know the impact of other inflationary things like war in the Middle East and how it's going to affect oil prices, because oil is a big component of our price gauges. So I would look at bonds right now and say they're there. We understand that we should have some, but I'm not sure that we should go with the blind faith that riskless treasuries are riskless. Treasuries are not riskless. They still can lose that value and I think there is some question about how we run our deficits and how we manage our country that are going to make it harder and harder for people to reattain that idea of the riskless status for US treasuries.

Clem Miller: 16:51

Steve, I totally agree with you that treasuries are no longer riskless. I don't know how you would calculate a risk premium on treasuries. You would need another risk-free asset in order to make that calculation, and I'm not sure that there actually is one that one could-.

Steve Davenport: 17:12

I think that Bill Gross had the term, which is we're the cleanest dirty shirt in the laundry. Yeah, and so I think all the shirts are wrinkled.

Clem Miller: 17:21

We all know that some shirts get more wrinkled and are harder to iron, but I think it's it's really a question and I personally I think it's a bit crazy for somebody to invest, for an individual investor to invest in anything that has a long duration investor to invest in anything that has a long duration. Personally, I think that long duration bonds are really something that institutional investors should hold. They're designed for institutional investors. They're not designed for you and me, right? If we're going to hold, you know, if we're going to hold bonds, in my opinion they should be bonds that are, you know, maybe just you know that you know are used as a substitute for cash. You know slightly longer duration, higher yields in cash, and if you can get that, I think that's okay as a diversifier. But I definitely would not go long treasuries. I would also be nervous about bond funds.

Steve Davenport: 18:41

That I would also be nervous about bond funds that go well beyond investment grade. Yeah, there's many ways that you can lose money, and I think that you want to understand what your duration is, you want to understand what your yield is and you want to understand if there's any other risks in this ETF or fund, and I think there are people who are trying to manage their duration by using swaps and other instruments that are derivatives, and those people are trying to minimize duration so that they can minimize the impact of a price change caused by a change in rates. I think that there are some good products out there and there are some good people out there doing good work. I think that people who promise you just a little bit more yield and you're really not taking much risk. You've got to ask the question well, what does much mean? And I think that, just like everything else, you're the person who has the most to lose, so therefore, you're the one who has to take this and try to work with it in a way that makes sense. I think that you're right, clem.

Steve Davenport: 19:52

I don't think a 20-year bond makes sense. I don't think a 30-year bond for an individual makes sense. When you look at those, they're usually for insurance companies and other people who have very long duration assets and they're trying to offset a liability with an asset that has a similarly long duration, and I think those people should use those assets. But the average person, somewhere between one or two and somewhere between seven or eight, seem like the ranges that I would. If rates were to jump up here and go back to six or 7% for a while and sit in.

Steve Davenport: 20:30

I think I might think about some of those, for, you know, there is a point at which you'd say I'm being compensated enough, and I think the question is we know that we need inflation to help us with our debt, and the question is how do we have a controlled inflation such that it allows us, as a government, to lessen our overall government debt? So I think it's going to be a discussion that we continue to have. I think it's going to be a discussion that we continue to have, and all I'd say is, just like, all that glitters is not gold, all that is riskless is not US Treasuries, so I'm going to put a stop there. Do you have any last points, glenn?

Clem Miller: 21:15

No, I think that's it. Good discussion, steve, all right.

Steve Davenport: 21:19

Again, thank you everybody for listening to Skeptic's Guide. We appreciate your support and we want you to share and like what you see, and if you have questions or ideas, please reach out and contact us. Thanks.