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02/06/2009
"Value in Bonds"
By
David B. Wellborn
Last month my colleague described in great detail the terrible results seen in the stock market in 2008. He compared last year to other infamous bear markets and showed how it truly was historic in its devastation, suddenness, and breadth. As he said, “there was no place to hide”.
Indeed. Unusually, one could not even rely upon bonds to soften the blow. At PMA, most of our clients hold fixed income in their accounts to dampen volatility and lower the overall risk of the portfolio. We manage the bond portion of the accounts in a very conservative way—typically we only hold short and intermediate maturities to avoid interest rate risk, and we invest in diversified funds that hold very strong credits—high grade corporate bonds and governments. In the times when we invest in high yield bonds, only a small fraction of the portfolio is devoted to that sector and even then only to the highest credits in that universe. The objective with our fixed income funds is not necessarily to build wealth, but as an insurance policy to help preserve it.
The reason this works is that generally speaking when bear markets occur in equities, there is a related downturn in the overall economy. This typically leads to lower interest rates across the board because the government attempts to stimulate demand through rate cuts, and because investors turn to bonds while stocks are deemed temporarily less attractive as earnings are weakened. When rates fall, bond prices go up.
The last two recessions bear witness to this phenomenon. In 1990 the S&P 500 fell about 3%, while the Lehman Aggregate Bond Index rose about 9%. The three year bear market of 2000-2002 saw the S&P fall 37%, while the bond index rose a bit over 33%. Therefore, a balanced portfolio in those bad markets would have avoided much of the bloodletting and indeed in 1990 turned a profit.
Last year, however, unless you ONLY owned government bonds, the fixed income markets provided no insurance and in fact added to losses in most cases. The S&P was down 37%, while the Lehman (now called Barclays, due to the acquisition) Aggregate was up only about 5%. Even this number is highly misleading, though, because the Aggregate index is composed of about 75% government or agency bonds.
Most investors own diversified portfolios that have far less government bonds as a percentage of their total assets than this. At PMA, our clients tend to have a higher weighting of high grade corporate bonds, since over most time periods (including the 5 and 10 years prior to 2008) these bonds outperform government bonds by about 1.5% per annum. Last year, however, there was a complete meltdown in all sectors of the credit markets, and even bonds issued by the strongest credits were dumped indiscriminately. Instead of outperforming governments, corporate bonds underperformed by anywhere from 10-20%, even in the short maturities. Short investment grade funds lost about 5%, even though the Fed had cut rates to almost zero.
This performance is unprecedented and has led to some interesting market situations. Credit spreads (the difference between the yields on comparable maturity bonds) were at their highest levels for 75 years in December. The average spread of a high grade portfolio of bonds was over 5%, giving a yield of over 8%. The average spread for most of the past 10 years has been closer to 1-1.5%. It is important to note that this huge widening of credit spreads is not being driven by bankruptcies or defaults. Remember, these are high grade bonds, and the default rate over the past 12 months has been a fraction of one percent.
What has been the cause of this collapse in the corporate bond market? Essentially it is contagion from the initial debacle in the mortgage bond market, which vastly weakened banks and other fixed income investors, who then had to produce liquidity anywhere they could find it. And that meant selling anything they could, even at severely depressed prices.
The government has set as an extremely high priority the “thawing” of these frozen credit markets. The original plan for the TARP program was for the Treasury to directly buy fixed income securities to bring liquidity back into the market. For whatever reasons, the strategy switched to buying equity stakes in the banks. This is fine for the banks, but leaves many other non-bank investors in the cold. Now there seems to be a movement to go back to the original plan, which would be helpful.
However it happens, we are confident that the capital markets of this country will start functioning again in a rational and efficient manner. Holding high grade corporate bonds did not improve client portfolios in 2008. At some point (and there has been some improvement already in 2009) this will change and investors will once again be glad they held a balanced, diversified portfolio.
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