Bond. Carnage Bond.

April 26, 2022

Bond. Carnage Bond.

Less than 2 short years ago when US interest rates were hitting historical lows, and there was talk that a key interest rate benchmark might actually go negative, I warned that in the coming years, losses in bonds from the then inflated prices would make the carnage of the dot com bust look tiny in comparison. At the time there were close to $17 trillion in negative interest rate bonds held around the world. That is right, people were willing to pay rather than collect money for the privilege of lending money to their government or other institutions.

Fast forward to today and the 10-year treasury that hit a low of around 0.5% is now approaching 3%, a nearly 6X increase in under 2 years. TLT, a bond ETF that tracks the 20-year bond, has decreased from a high of around $170 to just over $120. That is a loss of nearly 30%. For US treasury bonds. Declines like that in stocks would make daily headlines, but you hardly hear a peep regarding bond losses. Yet the US bond market is about $46 trillion, or over twice that of the US stocks. To show the extent of the losses for international bonds, the German 10-year rate went from -0.50% to around 0.85% today. The losses for international bonds, especially (formerly) negative rate bonds, is in the trillions.

Even though there had never been negative interest rates in the history of economics – and the conditions creating such instruments were likely to fade (with losses ensuing) - many investors could not look beyond the present and assumed conditions would persist indefinitely (the bad times). This was the polar opposite of the great internet-induced stock bubble of the mid to late-1990s when for several years it looked like prices of technology companies could only go up – and fast. Of course, like the bond bubble of 2020/2021, that situation eventually reversed and those who made decisions based on the (aberrational) moment were left holding the bag.

Lesson learned: when it comes to your investing or your asset allocation, you must always act with discipline, patience, and rationality. Very few situations – exuberant or ugly – persist indefinitely. Yes, they may last for longer than you want, or for longer than it seems like they ‘should’ (none other than our Fed Chair Alan Greenspan stated in 1996 that the stock market was in a bubble. He was right, just 3 years early). When the tide shifts, however, it can be fast and violent. You will never time the turn, so the best thing to do is to invest and allocate capital in ways that can survive any near-term aberrational situation. In the case of bonds for the last couple years, an environment of historically low and in some cases negative interest rates, you were best served to keep cash and equivalence in something that would not lose principal if and when interest rates normalized. When the 10 year was yielding under 1%, why reach for a measly yield (a few basis points more than you would earn by just leaving the cash in a money market or savings account) when the risk reward ratio was so skewed against the investors favor? Just as investors think the good times will never end, they believe the same when tough times strike

The Bear Has Entered the Room

I have written extensively on the best ways to not just survive, but to thrive during a material market decline. The main points are: 1) you will never be able to time short-term market movements (of any amount or duration), and 2) you need to build a portfolio which can withstand (and actually thrive) during any market near-term declines through dividend reinvestments at lower prices and potentially generating incremental income/profits from short calls. Attempting to dart in and out of the market at precisely the right time is imprudent at best, in most cases leading investors to sell low and buy high – and materially underperform those who take no action or better yet dollar cost average along the way.

Now that we are effectively in a bear market in the case of technology companies, and in terms of the broader market (e.g., the S&P 500) close to one, here are some additional survival tips:

Understand, before you invest a penny, that stocks can decline in the near term for reasons known and unknown. Over time 3-5+ years, a well-diversified portfolio of stocks tends to go up (the average bear market lasts less than a year and within a short time most people cannot even recall what headline caused the decline). As such, prepare yourself accordingly, and if you don’t think you can handle such inevitable drops emotionally or financially, then don’t invest in stocks – or better yet work with an investment professional who can help you overcome these fears and set forth a plan that will get you through the ups and downs to a better financial tomorrow.

Always allocate capital you will need in the next couple years to something other than stocks (cash, short term bonds, etc.). Do this regardless as to whether we are in a bear market, bull market, or sideways market. Make sure to match your holding period with the duration of the bonds you hold (see above for potential losses in bonds in a rising interest rate environment). Remember, there is no bell announcing when the music will (temporarily) stop, thus be disciplined.

Resist looking at your stocks/the market/headlines day to day. If you have a sound plan in place, then other for ‘entertainment’ purposes (and having your blood pressure rise is hardly a great form of entertainment), there is no need to be checking in daily. When we look at something constantly, especially if it is going against us, we often feel the need to ‘do something’ (this is typically a psychological need to be in control). That something is very likely to not be in our best long term financial interest, no matter how much it satisfies a short-term itch. Taken at its most basic level, an investor's ‘need’ to look at his long term holdings daily is simply a bad habit, and like any bad habit, it can be broken with some discipline and training.

As I wrote about in a prior article (The Stair Way to Financial Heaven), in exchange for potentially benefiting from the superior long term returns equities can offer, you need to be able to withstand some short term ups and downs along the journey. Accept this. Prepare for this. Don’t fight this or pretend these realities don’t apply to you. At a minimum ignore these fluctuations for your long-term money, ideally take advantage of them through regular market contributions (either through a retirement account and/or reinvested dividends) leading to powerful dollar cost averaging. Investors tend to believe whatever has happened recently – be it good or bad – will persist indefinitely, but history indicates otherwise. That said, be honest with yourself; if you feel you don’t have the emotional fortitude to resist making bad decisions (and most people do not have this discipline if working just on their own), then partner with an investment professional with decades of experience who can help you navigate choppy market waters.