Monday, 22 May 2017

Portfolio Strategy: US Long Bonds may be attractive on a relative basis

I have considered previously in my piece on Gold the elevated price of US stocks in general and I continue to hold cash in USD as I await better opportunities in general. So the question to be asked is should I hold that cash in US bonds rather than simply cash on account to generate some income in the meantime?

My answer is Yes and No. 

I believe the income element at around 2-3% on the longer dated bonds is not as attractive as the scope for further price appreciation of the long bonds in the future (i.e a drop in yields) and therefore the potential for capital gains.

Here is a quick consideration to be made for Benjamin Graham's metric regarding when investors should prefer stocks to bonds - when stocks yield more than 2x the AAA bond.

Current 10 year UST yield;   2.25%
Current CAPE S&P Yield;     3.45%
Current Trailing S&P Yield; 3.97%

Therefore at present the CAPE yield trades at 1.53x and the trailing at 1.76x. Both less than the 2x margin of safety. Now the UST is not AAA anymore and we have some very strange super low interest rates. But even so these metrics suggest bonds are preferable.

So as a guideline it would be prudent to consider the Bond market as more attractive today than Stocks in the US. Graham generally said defensive investors should avoid ever having less than 25% of their portfolio in bonds. But we must note that both the 2x metric and 25% may hardly be 'functional' by historical standards due the the central banking bubble.

The other angle is the macro thesis;


The US baby boomer generation is huge and they are retiring. In some sense the current lofty value of the S&P may be one last bubble to drive up their 401k values ahead of retirement where people want a fixed income. That means Bonds. From a structural demographic perspective the flows from equities into bonds in the next 10 years in the US will be a major headwind for the equity market. This creates demand for bonds - including government bonds.

Why not buy corporate bonds? 

I see a poor risk reward. Especially in High Yield bonds. The search for yield has driven up prices to extremely high levels (yields sub 6%) at a time when recoveries from default are extremely low and the US credit growth cycle is turning over - signalling recession. Which means demand for 'safe havens' which in relative terms for US investors means treasuries.

But isn't the US going bust? 

USD Debt/GDP - Trading Economics

US Debt to GDP is very high. They arent a AAA borrower anymore. But I think the US is turning Japanese. They have a captive audience in global trade due to the nature of the current account deficit in the US (a prerequisite for the world's reserve currency). They also have a huge demographic retiring at the same time in need of USD fixed income.

But the Fed is hiking rates - wont this drive up yields?

The Fed is hiking into weakness. And the market knows it - yields are not moving materially higher. I think even the Fed knows this but they are playing catch up to arm the arsenal for rate cuts ahead of the next recession. They are too far behind the curve now but they are trying to sneak in some rises without blowing up the S&P and destroying the wealth effect (which would compound  a recession.) 

USD 10Y Rate - Trading Economics

Therefore my argument is rate hikes tail off, and rates head back down again - lower for longer. So I expect to see long dated USTs rise in value - maybe not to the JGB level of 2bps yields - but yields down over the medium to long term as the Fed will be forced to do a U turn in the face of deteriorating US GDP.

So if that macro plays out I expect USTs to be a better option than USD.

What to buy?

I think TLT (NASDAQ:TLT). This ETF captures the longest end of the curve (20+ years) so has the greatest price sensitivity to changes in rates and rate expectations. 

So I will look to park some of my USD cash into TLT as I continue to look for good stock opportunities. I reiterate this is not a hunt for the ~3% yield on offer - I think the capital value will rise.

Tactically I might look for a sentiment based selloff in the long bonds following the Fed meeting notes. But these things can go either way - sometimes second guessing other market participants is a really stupid idea. i.e waiting for a dip to buy. We shall see.

Disclaimer: I have no interest in TLT as mentioned in this article at present but i may do in the future. These are opinions only, not investment advice. Construct your own portfolios with due care and attention.  If in doubt read my disclaimer.

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