Is the Next Bond Bear Market Cycle About to Begin?
Jim Grant, a leading expert on the bond markets, shares his predictions for 2022.
Jim Grant is the founder and editor of Grant's Interest Rate Observer, a twice-monthly newsletter on financial markets with a focus on bonds. He joins The Long View this week to talk interest rates, portfolios, and the bond market.
Here are a few excerpts from Grant’s conversation with Morningstar’s Christine Benz and Jeff Ptak:
Ptak: That's a good segue to the next topic that we wanted to take up with you, which is interest rates. Bond yields are rising as you just mentioned. Bond investors are staring at losses. Do you think this is just the beginning?
Grant: I'm one of the world's leading authorities on when the next bond bear market cycle will begin. I began looking for it some time ago. (Laughs.) But I do think it's upon us now. Something to know about the history of the bond market, something to know of use in thinking about the present and the future is that in the past, bond yields have trended in generation length periods. So, it's a characteristic that you don't see in other financial assets. You don't see it in stocks, you don't see it in – real estate is another financial asset type, you don't see it there. But interest rates, they declined for the final 35 or so years, the 19th century, that is the 1865 to 1900 or thereabouts. They went up for the next 20 years to about 1920, declined till 1946, rose from 1946 to 1981, and declined, as I say, for 40 years subsequently.
So, it is a thing – as the young folks say, it is a thing in the bond market for a trend once established to persist. And it might just be that we are embarked on an upcycle in interest rates and bond yields with all that implies for valuations and mortgage rates and house prices, et cetera, et cetera. It's an intriguing time. It's, as we say, in the journalism traits, great copy. But it's also a time pregnant with risk and of course, opportunity, being two sides of the same coin. But I do think that this wonderfully or frighteningly powerful updraft in interest rates is the start of something and to me, it has the feel of a reversal in trend.
Benz: So, bonds have been reliable stabilizers in diversified portfolios, at least over the past 30, 40 years. They've diversified stocks. Can they continue to fulfill that role, even amid rising interest rates? And if not, what are the alternatives?
Grant: Well, if rates rise, and of course, it matters a great deal how fast they rise. But if rates continue to rise at abounding pace, the 60/40 portfolio, that is 60% stocks and 40% bonds, that standby of the bull markets of the 80s and the 90s and the assets that portfolio standby is not going to work. Now, it's not all bad news for the bond holder when rates rise because you can reinvest coupon income at ever higher rates of return. That's okay. But you look at your statement of mark to market base and the price of that security – of that bond is going down. And especially, do bond prices go down when the coupons at which they were purchased are trifling. And that characterizes a great deal of bonds over many, many recent years.
You bought securities at 1.5%, at 2% or 3%. That explains why you've been reading that the first quarter saw the most violent destruction of asset value in the bond market since at least seven years of (indiscernible) not because rates went up so much to such a high level, but rather because the rates at which prices began to fall were so low. So, a 1.5% coupon on a long data security can fall a lot when that 1.5% becomes 3%. And that's kind of what happened in the first quarter. And can it continue? Yes. Would it be welcome? No.
One final word on precedent. The bond bear market that began in 1946, the one that lasted 35 years from 1946 to 1981, that began as a tortoise would begin its race with a hare. The yield at which that bear market in bonds began in 1946 was about 2.25%. And it was not until 10 years past that the same duration bond yielded 3.25%, 10 years to get the next 100 basis points in yield higher, one percentage point higher yield. So, history, if it were only more predictable, would empower and enrich the historians as it is most historians don't have two nickels to rub together. So, one must take precedent with many grains of salt. But for whatever it's worth, the violence of this upsurge in yields is unprecedented. In the few bear market sightings we have had, there aren't that many statistical observations, certainly not enough to make hard and fast laws. But this has been some light show in the bond market.
Ptak: So, maybe turning back to portfolio strategy, if you will, given the fact that it sounds like you're a bit pessimistic on the 60/40.
Grant: I wouldn't say pessimistic. I'm trying to be clear sighted. People who are optimistic, because they're wrong are no more helpful than those of us who are pessimistic and wrong. So, anyway, that was away from the pulpit for not – but carry on, Jeff.
Ptak: Maybe clear-eyed and sober might have been a better way to describe it. But when you think about alternatives to the 60/40 – I mean, there are different steps that one could take, for instance, adding commodities, more TIPS, perhaps it's expanding the sleeve of equities that have a modicum of pricing power or maybe throw off dividends. I mean, are there particular, sort of, tactics that you think that, sort of, an allocator would want to keep in mind knowing that there's the possibility that rates would rise?
Grant: Yes, you've mentioned some. Here's a good idea. I think people ought to go and visit the website of a firm called Horizon Kinetics. Horizon Kinetics is a sponsor of an ETF called the Inflation Beneficiaries Equity ETF. Now, I'm not saying to buy it. But I'm saying for an exercise in investing imagination, go to the website and look at the portfolio holdings of this ETF. Because what Murray Stahl, the very capable and successful investor who designed this, what he tries to do is to pick the stocks of companies that are good companies that will do well in almost any economic environment but are particularly suited to a time of rising prices because they exhibit the business characteristics of companies that have pricing power. And the ETF has been an okay performer. It has done certainly better than the S&P. It hasn't blown – it hasn't knocked the cover off the ball. But it has been more than okay performer. And as I say, it affords you a free education in what one very good investor looks for in the way of inflation-resistant equities. It's the kind of distinction you make with a wristwatch. Is it waterproof or water resistant? There's a difference. Before you set in the bath there's a difference. And I would say that the Inflation Beneficiaries ETF is inflation resistant.
There are other thoughts. I'm a gold guy. I believe that to the extent the world has gotten away from a gold basis or a precious metals basis in currencies, to that extent it has done itself no favors. But, again, for what it's worth, I'm not here to sell stocks, nor would I desire to, but gold mining shares have been the dogs of dogs. And if the inflation has to persist, and if the Fed is to lose prestige in the eyes of the world, people will look for alternatives to dollars, and they might take a fancy to gold, if so, they might conceivably, likewise, fancy mining stocks, which are near record cheap with respect to the underlying element itself, that is to gold.
So, there are some income vehicles too. You can look at a well-managed business development company that underwrites credits carefully and conservatively and pays out a good dividend. That's another idea. But the blunt and hard truth, Christine and Jeff, is that rising interest rates are the kryptonite of financial assets, they are basically unhelpful. Again, it's important to qualify that by the speed at which rates rise, but we are talking about – if we are talking about a persistent inflation, and if we are talking about a new long-term bond bear market, we are talking about a difficult time for financial assets generally, there's no getting around that.
Benz: Well, thinking about rates rising in the future, will debt service in the public and private sectors become the story of the next decade, given what a headwind that would create for those entities?
Grant: I think it will become a story. It always becomes a story, credit does. Money is the thing itself, and credit is the promise to pay money. And the way credit is priced or ought to be priced is with an eagle's eye on the capacity of the borrower to service debt in bad times as well as good times. But the trouble with good times, the trouble with prosperity is that you begin to think it's permanent. It's a high-grade problem to be sure, prosperity. Prosperity is a very high-grade problem. But we have had a long run of a growing GDP and a worldview that says the Fed can solve almost any financial problem through the liberal dispensation of dollar bills. It's up to the Fed, or the suppression of interest rates. So, the Fed has been rather predictably on the spot of financial accidents to lower rates and to ease access to credit. And the people who run corporations have not failed to notice. And they have loaded debt on private equity – portfolio companies, for example, those are the companies that private equity promoters take private, paying a lot of money for them and loading them up with a lot of debt. And as this bull market in bonds has run on, the terms and conditions of lending have become ever more liberal, and the fine print that is meant to protect a lender in a time of impairment or default, that fine print has become sparser and less rigorous. So, what long trending markets do is condition us to think the wrong things at the wrong time, the wrong time being the inflection point. By the time the cycle turns after a long run in one direction, people are inclined to believe that what has happened will continue to happen. And that's the rub, right? That's what makes life interesting. That's what keeps journalists in business. Things simply don't cooperate. Thankfully, where would I be if they did?