The Last Word on Bonds…For Now

The Last Word on Bonds…For Now

In Howard Marks latest memo, Time for Thinking, he makes the following observation:

Lower interest rates increase the discounted present value of future cash flows and reduce the a priori return demanded from every investment. In layman’s terms, when the fed funds rate is zero, 6% bonds look like a giveaway, so buyers bid them up until they yield less (thus I believe 97% of outstanding bonds yield less than 5% today, and 80% yield less than 1%). (emphasis mine) And Fed buying drives up the price of financial assets and puts money into sellers’ hands with which they can buy other assets, further elevating prices.

If Mr. Marks is correct that 80% of bonds now yield less than 1% due to increasing demand – possibly due to the renewed fear of the stock market – where does that leave investors nearing retirement or already retired?

It is, and always has been my belief, that the primary role of bonds is to help provide downside protection during bear markets. Whatever return is generated from bonds in a retirement portfolio is certainly of benefit to the portfolio, but should not be its primary purpose.

That said, the good news about bond rates being low is simply that investors seeking income are likely to return to the stock market given that bonds seem less likely to provide it than any time in recent memory. This drastic fall in bond yields has made the dividend yield of the S&P 500 look ever more attractive.

In addition to bond investors seeking income, there has been a tremendous surge in “money on the sidelines.”

The graphic below from the .gov site, Financial Research, shows the surge in money market funds through the pandemic. Since 2011, money market funds held steady around $3 trillion dollars. But since the start of the year, those assets have exploded and are now exceeding $5 trillion.

It seems reasonable to assume that some of the increase in money market funds is a result of investors selling out of U.S. equities through much of 2019 so far as the fund flows show.

At current, investor capital is seemingly tied to a combination of money market rates averaging about 0.08% and bonds yielding less than 1% assuming what Mr. Marks says is accurate, which given his reputation, I have no reason to believe otherwise.

My guess is that as we continue to watch the equity markets surprise nearly everyone, at some point investor capital will realize that they capitulated at the wrong time again (as the fund flows above show at market bottoms) and will eventually find its way back into the equity market. And those who wisely chose to stay the course just might be rewarded further for their patience.

But as they say, the market has a way of surprising the greatest number of people (myself included) so only time will tell.

Stay the Course,
Ashby


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