Sunday, May 15, 2022
I applied for a job with Bank of America Investment Services during a campaign to increase female hiring in the early 1990s. I had majored in public health education, so my background in Investment banking was limited but I spoke a good game so they hired me. Suddenly, I was working for one of the largest bond underwriters in the country with just enough bond knowledge to pass the licensing exam. I was immediately in over my head.
Then came the bond market crisis of 1994 which caused prices to fall sharply and yields to rise. The rout began in the United States and Japan and was precipitated by a 0.25 basis point hike in interest rates by the Federal Reserve. Having yet to hone my bond trading skills, I was hammered, but it was a lesson I never forgot.
I learned that bond markets might seem boring, but they rule the world and I would understand them better if I wanted to survive. It’s now 2022 and once again a 25 basis point hike by the Fed (along with expectations for further rate and QT hikes) is making markets vomit. We literally have the worst bond market since 1994, so now is a good time to remember those lessons.
Some things have changed since 1994 in bond markets, but not for the better. Rising debt issuance, the use of leverage and dark markets have only gotten worse. Many of the real problems that led to the Great Financial Crisis of 2008 have only been covered up, not structurally resolved, so that the estimated total of global debt markets is now around 250T. Can such a debt really be repaid? The answer is no, so the debt should be rolled over, but with rising interest rates, now at higher rates. If more capital goes to servicing debt, less goes to growth. It affects everyone, from countries to small businesses.
So should you be worried if you own bonds and can the carnage in the bond markets affect your stock holdings? Sure.
What happens in bond markets doesn’t stay in bond markets, so there are some important things to consider. If you own good quality bonds and hold them to call or maturity dates, the worst that can happen is that you get your money back plus interest. If you own bond funds, the fund owns the bonds, not you, so no money back guarantee.
The lower the quality (credit rating) of the bond or fund, the higher the coupon (interest), but with rising rates you will see much larger price drops on your statements with bonds of lower quality because they carry more risk of default and prices move in the opposite direction. produce. Right now, headline inflation is 8.5%, with real inflation being regional and even person-to-person, so you need to earn at least 8.5% to break even on bonds.
Normally, the longer the maturity, the higher the return, but sometimes shorter maturities can earn you more. This is called the inversion of the yield curve and it is generally a reliable predictor of recession. We have seen this reversal recently, so it may be a sign of danger ahead in the economy.
Some stocks will be more sensitive to rising rates than others. Companies that are highly leveraged, that use hedging or leverage extensively, or whose earnings are predictive of the future rather than the present will see greater price volatility as rates rise. Look for defensive (stages, healthcare, REITs, utilities) or price-raising (consumer, food, energy) companies or ETFs that will allow you to buy a basket of stocks in these sectors. Consider companies that have a track record of reliable and rising dividends to provide income or protect your portfolio from volatility.
Predicting interest rates is difficult, although the Fed has eliminated much of the guesswork. Their dot chart is meant as a guide, but as we’ve seen recently, interest rates can rise on their own without Fed intervention. Interest rates move with inflation, geopolitical risk and liquidity and we have problems in all of these areas. So you should ask yourself if you think inflation is transitory. Will the risk of a further escalation of hostilities in Ukraine be a lesson and even if they cease completely, will the sanctions against Russia be lifted? Will there be enough dollars to travel around the world to meet liquidity needs?
All new things to consider when investing in new assets or selling existing assets.
I know uncertainty causes anxiety for many, so I’m going to share with you the advice of a battle-scarred trader who helped me in the 1990s. He had a theory using three baskets that he would compartmentalize in his mind. He told me to visualize the first basket containing things over which I had full control (attitude and behavior) the second basket contained things over which I shared partial control with others (family, friends, professional relationships ) then the third and by far the largest basket contained things I had no control over. If you realize that most of what happens in the markets (and in life) happens in the third basket, you can plan better and be much less stressed.