2010 Q3 letter: Bonds and Bubbles, Breaking BRICs
Bonds and Bubbles
Over the course of the summer, various market commentators have put forth the idea that we are in the midst of a “bond bubble”. Since we advise substantial allocations to bond or fixed income investments, we thought it would be worthwhile to weigh in on this theory. Since we are fully aware that bonds, like every investment, carry risk and have the potential to lose money for the investor, we think it’s important to review those risks and explain why we believe that in the current environment bonds continue to be a preferred investment option over stocks and other higher risk securities.
We believe talk of a “bond bubble” is over-stated because their limited return potential (maximum return is repayment of principal and interest) tempers speculative excess (unlike stocks, which are far more sensitive to cycles of euphoria and despair). In general, we view bonds as less risky than stocks because bond-issuers have a contractual obligation to repay bond-holders, whereas holders of common stock are entitled to residual earnings. Bond holders are creditors and thus rank higher in the capital structure than stockholders; this makes recoupment of bondholders’ principal more likely in the event of a bankruptcy or default.
Bonds drop in price due to three main factors, rising interest rates, credit or default risk, and inflation worries. All these risks stem from the fact that a bondholder is essentially making a loan to an issuer who agrees to repay a fixed amount of principal, along with some interest.
In our view, the Federal Reserve cannot keep the fed funds rate at the extraordinarily low level of 0-0.25% for much longer. Fed officials see the dangers in maintaining extremely low rates since we have just lived through a large scale credit crisis fueled in part by central-banks suppressing rates for far too long. We expect spirited discussion after the mid-term elections on raising rates, and expect the Fed to raise short-term rates to 1.5-2% followed by a pause. We believe interest rate risks for holders of medium and long-term bonds are substantial at this juncture. That said, interest rate moves are typically measured and somewhat telegraphed by the Fed, and we expect any raise to be executed incrementally.
Bond prices also drop when investors are worried about default risk. This has typically been a concern for investors in corporate or local government debt. However, sovereign issues are not immune to default concerns, as demonstrated vividly by the collapse in Greek, Irish and Portuguese bonds this year. This default risk exists for all issuers who do not control the repayment currency. In the Euro-zone, monetary policy is controlled by the European Central Bank, not individual country’s governments or their central banks. In this respect, individual Euro-zone countries are closer to individual US states than the United Kingdom, USA or Switzerland which control their own currencies.
US investors have begun to focus on default risk for municipal bonds after a rash of high profile defaults or near-defaults (Harrisburg PA, Vallejo CA, and Jefferson County AL). Historically, municipal bond defaults have been lower and recovered amounts after default higher than those for corporate bonds. However, numerous US states and localities are extremely stressed by the real-estate crisis and recession so historic comparisons may be unreliable. Weak economic conditions, coupled with longer-range questions about pension obligations and eroding tax bases in certain regions have negatively impacted most US state and local finances. We recognize these risks, but are reasonably confident that the political process in most states will tackle fiscal issues responsibly and issuers will honor pledges made to bondholders. We do expect fundamental pension reform by states to control costs, and state workers will see retirement ages extended and rely on 401k-style retirement plans rather than defined pensions. Both corporate and municipal bond markets have weak issuers and our role as investment advisors is to identify and avoid them. Just as we analyze companies and industry conditions, when we invest in municipal bonds, we review regional economics, taxing ability, project viability and overall financials to gauge credit risk independent of ratings. In 2009, we recommended purchases of corporate and municipal bonds as concerns about repayment were elevated and bonds were available at very attractive levels. Over the past year and a half, these concerns have receded and prices for corporate and municipal bonds have risen to the point where we have considered taking gains by selling positions.
This brings us to the last risk to bonds: inflation. Inflation is the most difficult risk to manage because it’s unpredictably influenced by an array of macro-economic factors (commodity prices, money supply, interest rates, factory/labor under-utilization etc). Its impact on the bond market is profound since it destroys confidence by undermining the real-value of future principal and interest payments. Bond investors are justifiably fearful of inflation.
We recognize the risks in bonds, and our goal as investment advisors is to make intelligent decisions while balancing risks and potential rewards. We know of no investment that carries zero risk. The risk of any particular investment performing poorly rises if we pay too high a price to acquire it. Even sound securities can be bad investments if we pay too much for them. This is part of the reason we consider ourselves value investors – we like knowing what things are worth before we buy them, we like to buy when levels are cheap, and we generally intend to hold investments for the long term (for individual bonds, this usually means to maturity). This applies equally to bonds and stocks, and it is undeniable that many bonds are currently above the price a prudent investor would pay. As a result, we are looking for opportunities to sell bonds where we believe price appreciation has changed the risk-reward scenario.
If we do sell these bonds, we have to consider re-investment options. We have discussed the possibility of purchasing stocks of high-quality, financially strong companies with cash on hand if the opportunity arises. Since we will continue to hold some bonds for all clients, we have sought to limit interest rate and credit (repayment) risks by shifting investments towards financially stronger issuers and limiting bond maturities (i.e. focusing on shorter-term bonds or bond funds). We believe inflation risk for US based investors are low, yet we have opted to limit inflation risk by keeping maturities short. We are presently not recommending investments in long-dated bonds (over 7 year maturities).
Risk On, Risk Off
Over the past few months, we have seen an increase in the degree to which different markets move up and down together. As various writers have noted, correlations between different stock markets have increased. Surprisingly, this has been happening with equity market volumes at very low levels in developed countries. Indiscriminate buying or selling can create opportunities for value investors and we are willing to take risk when rewarded well for it. We are actively on the lookout for such opportunities.
Political Update
It’s a mid-term election year in the US and we have begun to see a lot of posturing and maneuvering by the political establishment to prepare for the November 2nd election. The big story for this election will continue to be the state of the economy and persistent high unemployment levels. The national mood is anti-incumbent, anti-Washington and we expect Democrats will lose House and Senate seats in this election cycle.
It is difficult for politicians to support free trade when unemployment is high, and these are certainly trying times for many workers in the US and Europe. Every developed country would like to export its way out of this recession, but the entire world cannot do this at the same time. High unemployment, low growth, large budget deficits and an impatient electorate can lead to irresistible pressures to enact protectionist policies in a short-sighted attempt to “keep jobs and industry at home”. Rising trade barriers slows growth since it disrupts the global supply chains that virtually every industry relies on. Only sustainable, balanced growth in both demand and supply can cure what ails developed economies, and we would be better served if elected representatives focused on encouraging sustainable global growth rather than protectionism.
Breaking BRICs
One of the great challenges confronting the world is how the rapidly developing economies of Brazil, China, Russia and India will be integrated into the broader global economy. Thus far, they have been very successful as production centers of exportable goods and services. However, as consuming and investing economies, their collective record is far more checkered. China is a particular concern since many industries remain firmly under state control and consumption is a very small portion of GDP. Capital and currency controls remain very rigid in China and most of the recent international tension has surrounded the floating peg maintained by Chinese authorities between the CNY and USD. There are other fundamental institutional issues which affect China’s economic links to the world. The Chinese legal system for one remains unpredictable and tightly under the administration’s control. We have seen a number of instances where prosecution and arrest have been used to compel certain outcomes and actions from foreign businesses. The recent wave of worker-led strikes and suicides at factories in China also betrays the fact that state-sponsored trade unions have not been representing workers’ interests. Severe political repression of both workers and citizens leaves us concerned that discontent could quickly boil over into civil unrest provoking an unwelcome response from authoritarian regimes in both Russia and China.
In previous letters, we’ve written about the many imbalances and distortions we see in the Chinese economy. We believe these concerns remain valid and we have begun to think about them and about the BRIC economies as a whole, in a slightly different way. We now see a distinction between Brazil and India on one hand, and China and Russia on the other. China and Russia remain heavily state-controlled, resource-intensive economies with repressive political environments, weak domestic consumption and a poor demographic outlook. We believe future high growth in these two economies is not based on sustainable foundations. In contrast, while growth in Brazil and India has been slower than in China and Russia, we believe it is more sustainable. Political institutions in both countries are relatively democratic, state control of industry is limited and their legal systems, though notoriously slow and complex are not blatantly unfair. Both Brazil and India have young populations with large numbers entering the workforce and this “demographic dividend” should lead to impressive growth over the next two decades. This is not to say that Brazil and India do not face challenges; poor basic education and high inequality for instance are two issues that demand attention. Still, it seems to us that these two countries are on a far more sustainable path than either China or Russia. We will be taking a closer look at investments in India and Brazil, while our macro-view on China and Russia is more downbeat. As always, we do not anticipate investing unless prices are attractive.
The Social Network
On the social media front, we wanted to let you know that you can now follow us through the following platforms online:
- blog.wsqcapital.com – our blog.
- facebook.com/wsqcapital – our page on Facebook
- twitter.com/wsqcapital – our Twitter feed
We look forward to speaking with you during our quarterly review.