Investors around the world are worried about the long-term safety of U.S. Treasury bonds, and many are cutting back their holdings. In part, this is simply because we’re at the point in the economic cycle at which Treasuries typically perform poorly. But something else is going on, as well – something more profound that will permanently change the rules of investing.
The near-term economic problems for bond investors are obvious. The Federal Reserve has been holding interest rates abnormally low. That can’t continue indefinitely, especially not once the economy starts to recover. And when interest rates rise, bond prices fall. Pimco’s Bill Gross, the most visible bond fund manager in the U.S., predicts that coming interest rate increases will cook bond investors like a frog in a pot of water heating up on the stove.
There is, however, a deeper and more complex issue that forecasters are largely overlooking — but that may be far more important in the long run. To understand it, you need to take a detour through the investing theory of the past 50 years. I’ll keep it brief.
All modern portfolio theory is based on something called the “riskless rate of return,” defined as the yield on Treasury debt. But what if the riskless rate of return is no longer riskless? Government debt doesn’t have to fall to Greek levels for this to be a problem. The prospect of any downgrade at all is enough to make the ground shift under our feet.
Traditional portfolio strategy consists of balancing the risks of investments such as stocks with bonds that have no risk of downgrade or default. These bonds may dip in value when the economy speeds up, but they rise in value when the economy slows, allowing interest rates to fall. As a result, they are the perfect counterweight to stocks that thrive in boom times and languish in sluggish economies.
If there is no such thing as a riskless rate of return, however, then the textbook split – 60% stocks in the S&P 500 index, 40% in long-term government bonds – arguably stops making any sense. Maybe it would be smarter to abandon bonds altogether and put together a portfolio composed entirely of high-yielding shares of companies with the strongest balance sheets. Stocks certainly are better able to keep up with inflation than bonds are, since dividends can be raised over time as earnings rise, while bond payouts are usually fixed.
Or perhaps it still makes sense to own fixed-income investments, but they should be high-yield bonds and preferred shares whose 6%-plus yields offer a fat cushion against interest rate upticks caused by rising inflation. Or maybe the real problem is the dollar, and it’s now essential to invest outside the U.S. – in German bonds, for example. Do dollar-denominated stocks need to be balanced by fixed-income investments in a different currency like the Euro?
I don’t know the best answers to these questions – and neither does anyone else. Academics will spend the next decade running regression analyses trying to discover the new optimum investing strategies.
What I do know is that most conventional wisdom about investing is ultimately based on mathematical models that start with a riskless rate of return and then use it as a benchmark for everything else. Without the riskless rate of return as a baseline, modern portfolio theory is uncalibrated, like a guitar amp that’s said to perform better because the volume control goes up to 11.
It’s time to return to traditional ways of assessing investments and combining them into portfolios. Basically, that requires hard-nosed judgments about the character and responsibility of the people with whom you invest money. The Federal Government doesn’t score especially well on those scales.
Moreover, there’s no real case for owning fixed-income investments that pay little premium over the inflation rate but could suffer from a jump in interest rates or a downgrade in U.S. creditworthiness. In future columns, I’ll look more closely at portfolio strategies and specific investments for today’s more unpredictable environment.