Back off, bond haters. Not only do bonds deserve to be in your portfolio despite their near zero yields, they deserve an even bigger place than normal.
That is the surprising contention of Roberto Perli, head of global policy at Cornerstone Macro, an investment research firm in New York. This past week, he published two reports that argue U.S. Treasury bonds – the world’s flagship fixed-income investment – are still undervalued, despite big gains this year.
“It’s a little bit counterintuitive, but it is easy to explain,” says Mr. Perli, a former senior staff member at the Federal Reserve Board. By his reckoning, investors are underestimating the chances that bond yields will fall even lower than today’s already low, low levels. If such a decline occurs, bond prices, which move in the opposite direction to bond yields, will go up and bond investors will profit.
To say that not everyone agrees with this positive outlook for bonds is an understatement. In recent months, a small mob of market pundits has chorused the case against owning fixed-income investments. The bond skeptics, ranging from Jeremy Siegel of the University of Pennsylvania to Ben Inker at money manager GMO LLC, argue that savers are locking in losses by buying fixed-income securities at current miserly yields.
With 10-year U.S. Treasuries yielding only 0.84 per cent, and 10-year Government of Canada bonds paying out an even stingier 0.64 per cent, the concerns of the anti-bond crowd appear reasonable. At current payouts, these investments actually shrink your buying power after accounting for the corrosive effect of inflation.
To make matters worse, many analysts expect interest rates to rise in coming months as the economy recovers. If so, bond prices will suffer and bond holders will sustain losses.
To prevent potential setbacks, authorities such as Mr. Siegel recommend investors own fewer bonds than normal. Instead of the time-honoured 60-40 asset allocation – that is, 60 per cent stocks and 40 per cent bonds – Mr. Siegel urges a 75-25 approach in which only a quarter of a portfolio is devoted to bonds.
Mr. Perli begs to differ. In one of his reports this week, he recommends investors nudge up their bond holdings to 45 per cent of their portfolios.
“We are getting a lot of push back” from clients on the pro-bond call, he acknowledged in an interview. But he is sticking to his convictions. To his way of thinking, Treasuries deserve a place in portfolios for several reasons.
For starters, they diversify your holdings. They also act as a hedge, or counterbalance, to risky assets. On top of that, North American bonds remain attractive to foreign investors because yields in the United States and Canada easily surpass what is available from bonds in other haven countries such as Germany or Japan.
“A structurally weak economic outlook” means U.S. Treasuries in particular will remain in high demand, Mr. Perli adds. He also expects the Federal Reserve to “remain supportive of Treasuries for years,” both through continued low interest rates as well as through continued direct purchases of bonds.
All of this leads to his most surprising assertion – the notion that Treasuries are actually undervalued. Mr. Perli arrives at that conclusion by running millions of computer models. The models incorporate consensus forecasts for growth, inflation, budget deficits and other key economic variables. Each model offers a separate forecast of what the 10-year U.S. Treasury yield should be, given those fundamental assumptions.
The average forecast of all these models? Between 0.50 and 0.55 per cent, well below the bond’s current yield. In effect, the models are saying that yields are low today, not because the Fed is artificially suppressing them, but because underlying economic realities dictate they should be low. That implies a substantial profit may lie ahead for owners of mid- to long-term Treasuries when yields fall back to what the models consider reasonable.
While Mr. Perli doesn’t explicitly consider Government of Canada bonds, it seems reasonable to expect that similar forces would hold sway on this side of the border. At the very least, his calculations suggest that today’s near-universal condemnation of bonds is an overreaction.
He has some notable company in making a case for bonds. Scott Minerd, the global chief investment officer at money managers Guggenheim Partners in New York, wrote a note this week arguing the global economy is in the eye of the storm – a zone of apparent calm before even greater turbulence.
He pointed to new outbreaks of COVID-19, the lack of new fiscal stimulus in the U.S. and the chance of a contested presidential election as gathering storm clouds. The stock market could well go lower, he predicted, while yields on the U.S. Treasury could plunge.
“Before the end of the year there is a good chance that we will see the 10-year note at 10 basis points,” he wrote. (A basis point is one-hundredth of a percentage point.) Ultimately, he said, a yield of negative 50 basis points on the 10-year Treasury note and around 1 per cent for investment-grade corporate debt are likely.
To be sure, there is always a wide range of uncertainty around such forecasts, so take them with an exceptionally large grain of salt. But consider them a useful counterbalance to the prevailing anti-bond skepticism. If Mr. Perli and Mr. Minerd are even partly right, you will be happy to own bonds over the coming months.
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