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The One Reason to Own Bonds

Published on June 1, 2020

Peter Mallouk
President & CEO
Jonathan Clements Headshot

Jonathan Clements
Director of Financial Education

Hosted by Creative Planning Director of Financial Education Jonathan Clements and President Peter Mallouk, this month’s podcast looks closely at the far-reaching economic impacts of Covid-19. They also discuss the pandemic’s acceleration of brands’ transitions; why foreign bonds are currently a no-win proposition; and how you just might locate long-lost assets among the rubble.

Time Stamps: 

[0:00] – Bear Market rally from S&P decline of 34%

[3:27] – Pandemic’s effect on corporate earnings

[6:00] – Bonds’ performance through the downturn

[10:24] – How the Federal deficit and investors are impacted

[12:20] – Assets’ allocation vs. location

[14:20] – Peter and Jonathan’s tips of the month


Jonathan: Hi. This is Jonathan Clements, Director of Financial Education here at Creative Planning in Overland Park, Kansas. With me is Peter Mallouk, president of the firm and we are down the middle. So Peter, we’ve had this sharp drop in the S&P 500 down 34% and then this extraordinary rally. What’s going on? Can this continue or should people brace themselves for a setback?

Peter: So, from the beginning, we’ve talked about, this is all about COVID-19 and where it goes. And I think today, we still don’t know with certainty, right? Regardless of how you feel about all the information, no one can say with certainty, we’re not going to have a new spike or a new spread. So for example, we know there are more than 500 different mutations of this virus. And we know that with coronaviruses, some of them get easier, some of them get worse, we don’t know what’s going to happen here. So it’s a probability game. If you are an investor with total certainty that this is all completely overblown and everyone’s going to go back to work and there’s not going to be any spreads or spikes, you can take your whole portfolio and put them in airline stocks and cruise line stocks and probably be very rewarded for it. Now, for the rest of us that don’t have total certainty, regardless of how we feel about it, you stay diversified.

And large company stocks, they did well, relatively speaking through all of this because really this was an environment where the strong were going to survive regardless. The McDonald’s and Chipotle were going to survive regardless but the smaller restaurant chains, not necessarily. So you saw stronger companies like Walmart and Costco really be the beneficiaries of the weakness of smaller companies. You also saw this transitions that happen normally anyway over a period of years, in recessions tend to become accelerated. And we saw that here too, like the move towards online video conferencing. Services like Zoom or using Amazon even more. We already had doors shuttering every day in retail, but they just shuttered quicker, accelerated. It was already happening with the move towards the big boxes like Walmart, Costco and also online like Amazon.

But when you do see in all recoveries and most recoveries is false starts. You see this optimism that things are going to get better and it’s not necessarily so. That happened with the tech bubble multiple times, with 9/11 multiple times and 08-09 is famous for having many of the top 10 days of all time positive days that turned out to be false starts. Is this a false start or not? Nobody knows, right? And that’s why it’s important to stay diversified.

But there is real reason for optimism. We do now know that the risk of dying if you get this, is far below 1%, right? Before there was a lot of debate about what that was. We do know there are some treatments that are showing some promise and hundreds of more are on the horizon. And we now have three major pharmaceutical companies, all of which believe that they’re on track for a vaccine this year. Now, we don’t know what’s going to happen, but there is actual real reason for optimism besides just this crazy false hope. We have real reasons to believe that one way or another we’re going to contain this sooner rather than later.

Jonathan: So, Peter, I mean, you talk about progress against the coronavirus, but in the end, I mean, what investors care about is corporate earnings, right? And they only care about the coronavirus to the extent that it affects corporate earnings. So if we manage to revive the economy, even while the coronavirus is among us and even spreading rapidly, it may still be a fine time for the stock market that the people shouldn’t necessarily be looking at the rate of infection and the fatality rate and so on to decide their stock market strategy.

Peter: Well, I think they’re pretty tied together. So I think obviously, there’s extreme examples like say the airlines. If it’s spreading rapidly, the airlines are going to go bankrupt. If it’s spreading rapidly for the next 12 months, the airlines are not going to survive 12 months. Some hotel chains won’t survive that. Many restaurants, maybe the majority would not survive that. Companies like Disney World would get hit very hard. So people have to feel safe to go about their normal business. And you see how that impacts earnings. Are there winners if we don’t feel safe? Yes. Like the ones we talked about before, the grocery stores, Costco, Walmart, you mean, places like the pizza delivery shops. But I think this is mostly really about the coronavirus and how long is it going to take us to go about spending.

The issue is, this is a domino effect and it works in reverse. If we have all of these kinds of industries we talk about go under, they lay off people, then those people can’t go buy things. The same thing happens in a recovery. If people feel safe going and doing those things, people are going to rehire at restaurants, people are going to rehire at airlines, people are going to rehire at hotels and we can recover quicker. So I really do think coronavirus is directly tied to earnings and the speed with which we can get back to work is going to be the speed with which we can have a real recovery and have minimal carnage. Every week that goes by, we will see more bankruptcies.

So I’m very hopeful that we have found a way for everyone to go back to work and that the spread is not going to come back rapidly and that we will see a real recovery here. But if we really have a spike, especially in major cities, that is sustained, I think it could be very discouraging what happens from there. So I think these next 30 days are going to tell us a lot.

Jonathan: So, for the past three months, Peter, we’ve been fretting about the stock market. Everybody’s got their eyes glued to the Dow Jones Industrial average every day. But in the meantime, there is this other major asset class, bonds. And some really interesting things have gone on in the bond market in recent months. And this year, anybody who looks at their portfolio will see that if they have bonds that were issued by the federal government, treasuries mostly, those who’ve done pretty well. Meanwhile, Munis and high-quality corporate bonds have had pretty modest gains this year. And of course, high yield junk bonds issued by shaky companies have taken a dropping along with the rest of the stock market. So what are the implications by how people should manage their portfolios going forward?

Peter: Well, I think this is fascinating because for my entire career and really for all of financial investing in the United States from inception, we’ve counted on if you loan money to the government, the government will pay you some money and they’ll pay you interest for that loan. And that loan, which we call a treasury, dictates almost all other returns. So a municipality or corporation has to pay the investor a little more after taxes to induce the investor to loan their money instead of the federal government. We’re never worried about the federal government paying us, they’ll just print more money or tax people to pay us. But we worry a little bit about a county. Counties can go bankrupt. We worry a little bit about corporations, which as we know can go bankrupt.

But all of them tie their rate to the treasury. They always have to pay a little more. So if the treasury is at six, they’ve got to pay more than six. If the treasury is at zero, they just have to pay more than zero. And then even stock market returns in the long run are tied to the treasury because the expected return of the stock market is just a little bit maybe four or 5% more than bonds. So where that treasury is matters a lot.

And what we’re seeing for the first time is in mass outside of the United States in developed countries, the expected rate of return of bonds outside the U.S. is zero or even less than zero. Right now, the expected five year return of bonds outside the U.S. in developed countries is less than zero. You put a $100,000 in a bank in Germany, you’ll expect a year later to take out less than a $100,000. I mean, this is mind blowing to people. When I tell this to clients, they go, “Well, why would anyone in Germany put the $100,000 in the bank?” I say, “Well, where are you going to put it?” Right? “Well, I’ll put it in stock.” “Well, stocks can go down 50%. So if you’re okay with that, expect stocks will do better than the bank. But if you really are worried about markets, you’re going to put your money in the bank.”

In the U.S., this was unthinkable and this is sneaking up on everybody. And really this is going to be the permanent, when I say permanent, like many years, consequences of this is. The Federal Reserve has really lowered rates. We had a 20 year treasury recently for the first time and I don’t know how many decades, and it came in around 0.6. Loan money the federal government, you’re going to get 0.6 to 0.8 a year over 20 years. Unbelievable. Unthinkable years ago. If you look at a survey of the economists in the United States of the Federal Reserve, all of them expected rates to go higher over the last 10 years. They’ve been wrong all the time.

So what does that mean to investors? When you’re running a financial plan, you assume there’s an inflation rate. And the inflation rate that most people are using is around two. It’s probably too high, it’s probably going to be a little lower than that. We have to change the way we’re looking at inflation. The expected rate of return of bonds that a lot of people use in portfolios has been two, three, four more percent. That’s out the window. The expected rate of return of bonds has to come down.

So the way say at Creative Planning client has been looking at their financial plan from 2004 to today, is assuming inflation’s going to be around 2%, not probably what we’re going to be doing going forward. We’ve been assuming a rate of return of six or seven, probably not what we’re going to be doing going forward. Now, what’s interesting is when you put all this in one end of the machine and come out on the other, if you wind up with an inflation rate of one and a half and a rate of return of five and a half, you get to the same 4% real rate of return. But it’s a new way of thinking. I think that’s going to be surprising to a lot of people.

Jonathan: So of course, if the treasury can borrow at less than 1%, which it has been of late, just a quick segue here, one of the things that people shouldn’t be worrying so much about is the size of the federal government deficit. If they can borrow and pay at these low rates, the cost of carrying this debt is going to be substantially lower, which of course is also a reason why people should be thinking about refinancing their mortgages because they’re going to be able to take on some very low cost debt at this juncture. But if the government is borrowing at 0.6, 0.7%, why would you want to be buying, Peter? Why would you want to have bonds in your portfolio if the yield is going to be less than the inflation rate?

Peter: I think that the only reason is to have money in reserves if things go wrong and things always go wrong. See, you always have to have money set aside for a period of years, five, seven, depending on how you feel about risk, so that no matter what happens in the world, which usually directly hits the stock market, there’s money available for you to go to meet your cash flow needs. But other than that, there is no longer any other reason. Used to have a long list of reasons, income and so on, out the window. I mean, think about the way we think about asset location. For our whole careers, we’ve told people, “You put bonds in IRA where you don’t pay taxes. Put stocks in the taxable account. Well, a lot of stocks are paying higher dividends than bond yields now and we’re going to have to revisit the most basic concepts of the way that we approach investing now because of where the treasury is.

Jonathan: That’s a really interesting point about the asset location. It’s something I’ve been thinking about as well, whether it’s time to flip that old advice about tax-efficient stocks in your taxable account and having your fixed income in your IRA. So you have this choice now, right? You can buy government bonds and get this very low yield, or you can take a little more risk and get a higher after-tax yield from corporates, from Munis. How do investors figure out how they’re going to play that dance, where do they want to be?

Peter: I think the key in my opinion on the bond side is, it’s a place for quality. I’ve never understood, for example, 20% allocation to high yield bonds. I mean, you may as well be in stocks because if the market gets crushed, your high yield bonds are going to get crushed. You can’t rely on them. And the upside, you may as well be paying capital gains instead of income taxes on the stocks. Quality, quality, quality on the bond side and what kind of bonds you own has a lot to do with your time horizon and your tax bracket. You’re in a very high tax bracket, you need money to come to you over a period of years, you might look at municipal bonds in your state depending on the quality of your state where you won’t pay the federal income taxes on it. So I don’t think there’s a one size fits all there. But I will say that sticking with quality loans, meaning you’re loaning money to corporations and government entities where we have extremely high degree of confidence that they’re going to be around to pay you back.

Jonathan: I think one of the things we learned from the great financial crisis and what happened in 2008 and again this time around is that if you want something that’s going to be there when the rest of the world seems to be unraveling, you want to be in very high quality bonds and that taking credit risk may give you a little bit of extra yield along the way, but when it matters, when you want your bonds to be there, having good credit quality really pays off. We saw it this year, we saw it in 2008, and I think it’s really a lesson going forward and doesn’t mean you’re going to be buying stuff that may have a yield less than inflation rate so you’re going to have to hold your nose a little bit, but if you want that portfolio protection, that’s the price you pay.

Peter: Now, we’re going to be paying for the protection instead. That’s a perfect way to put it, Jonathan. We’re paying for the protection now versus being paid less than stocks for the protection later. The money’s going the other way probably.

Jonathan: All right, Peter. So it’s that time of the month. You got a tip for us?

Peter: So, I think investors, my advice to them is to revisit their bond allocation. That’s very boring. Everybody just talked about bonds for a while, but I think a lot of people have taken the view that, “If I’m going to just have a certain allocation of bonds and if I can be 70% bonds because I don’t need to take the risk in the stock market.” Let’s say you’re in a bond mutual fund, those bonds as they come due in that fund, they’re not buying 4%, 5% bonds anymore. They’re buying bonds that pay much less. And so it’s time to ask yourself, is this the right allocation to bonds for me? Or can I get by with less because possibly in a diversified stock portfolio, I can get higher yield. Really, this is a time to really start to revisit the thinking around your allocation.

Jonathan: All right. So, I’ll throw you a question, Peter, here. The late Peter Bernstein, author of Against the Gods, used to write back in the 1980s about how instead of having the classic bounce portfolio of 60% stocks and 40% bonds that maybe a better portfolio in terms of risk-reward, was to have 75% stocks and 25% in cash investments. Is it time to revisit that idea?

Peter: Well, I think if you look at the historical performance for that, anytime you add more stocks than bonds, you do better. But as you’ve owned cash instead of bonds, you’ve done worse. So I have always been a believer in less… Instead of looking at the traditional 60/40 portfolio, I have always taken the point of view of have the least bonds possible. Like the stocks for the long run. Stocks will do better than bonds over the long run. They should do better than bonds over the long run and that the bonds present a false security because if the stock market really falls apart, say 08-09 or what happened in March this year, if we really have a total collapse, bonds are going to default. No one’s going to be there to pay the taxes for the municipal bonds to work out.

So I’m not only agree that the more stocks you have the better you’re going to perform, but I also think that bonds don’t pay the existential protection that people think they do. And so my advice to investors is, own the bonds you need for the short run and nothing more. And for most of our clients that means having an allocation to bonds of less than 40%. Now, it winds up being 40 or more. Some people say, “I want to have the least amount of risk and volatility to have the income I need for the rest of my life.” And so it’s kind of making sure what does that individual person need and how do I get it to them, but with a bias towards the least amount of bonds possible.

Jonathan: But substituting cash investments for bonds?

Peter: I’m a hard pass on that, although if bond yields go a lot lower that I think that’s going to become the reality of cash pays anything.

Jonathan: All right. So for my tip of the month, while you’re sitting at home, go on the internet and go to unclaimed.org and what you can do at that site is search for unclaimed property for yourself or for your parents. It might be that there was a security deposit with the local utility that you never reclaimed. It might be some shareholdings that got lost along the way, a dividend you never collected. Maybe it’s an old bank account that belonged to your mom or dad. So go to the site, put in your name, put in your parents’ names. You need to put where they were living at the time. You might want to try different variations on their names because sometimes you need to do that in order to find any unclaimed property, but it could be a quick way to make a couple thousand dollars.

Peter: It’s great advice. I would tell everybody, do not blow that advice off. We send that to our clients every year and we are blown away by the amount of stuff that winds up getting claimed. And just the amount of our employees every year that we send a reminder that send emails of what they found. I think people are going to be surprised if they follow your advice and how good it may turn now.

Jonathan: All right, Peter. Well, that’s it for us for this month. This is Jonathan Clements, Director of Financial Education. You’ve been listening to me and Peter Mallouk, president of the firm and we are down the middle.

Disclosure: This commentary is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable, but is not guaranteed.


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