Market History

Using the past to rationally predict the future.

Bonds are the worst investment of all time and why interest rates are going up

I don’t short markets. I usually only play on the long side. But if you pointed a gun to my head and asked which market I’d want to short, it is definitely the bond market.

*Keep in mind that falling bond prices = rising interest rates. Rates and bond prices move inversely.

Why on earth would you want to buy bonds right now?

I have no idea. Perhaps you’re crazy.

When I talk about bonds, I use the U.S. 10 year Treasury bill as my point of reference. Most bonds in the U.S. move in sync with Treasury rates, and since the U.S. is the leading financial market of the world, what happens to U.S. Treasuries will impact global interest rates.

Right now the 10 year is yielding a little over 2% a year. Let me repeat that. 2% a year.

2-3% a year sucks. It really does. With every investment there is a risk that it will lose a substantial amount of money. This risk might be small, but you want to be paid a high enough rate of return to make up for those odds. Investing is all about a game of probability.

I’d rather sit on cash and earn 0% a year than accept this risk in bonds right now. Investors who are still buying bonds remind me of the banks who were selling credit default swaps for tiny premiums in 2006. Back then, the banks were being paid 1-2% a year on insurance policies against a collapse in U.S. housing prices. Well the banks got their 1-2% a year for a few years. Then the market reversed in 2007-2008 and they got killed. It’s not a good idea to make 8% over 4 years and then lose 70% in your fifth year. That’s what the banks did, and that’s what bond investors are doing right now. This is exactly how you get killed in the long run: invest in assets with small and limited upside but huge potential downside.

Yields are going up in the long term

No matter how you look at it, interest rates have approached a long term bottom.

The chart above is from Barry Ritholtz. Although it hasn’t been updated in a few years, it is still relevant because interest rates have not really gone above 3% in the past few years.

In other words, interest rates are at HISTORIC LOWS. And by historic, I don’t mean “post-Great Depression” lows. I mean “since the beginning of the financial markets” lows. Literally all-time lows.

There is a common misconception in the market. Some investors believe that the Federal Reserve controls long term interest rates. This is simply not true. No government agency can control the market because the market is simply too big.

The market leads the central bank, not the other way around.

  1. When the economy grows too strong towards the end of the economic expansion cycle, the Fed has NO CHOICE but to raise rates because not doing so would lead to soaring inflation.
  2. When the economy slows down at the beginning of an economic contraction, the Fed has no choice but to cut rates because not doing so would worsen the upcoming recession. Market conditions are conducive to the Fed cutting interest rates. Corporate rates and long term Treasury yields are already ready to fall before the Fed cuts rates.

Right now, market and economic forces are “bigly” bearish for bond prices and bullish for rates.

  1. The economy is growing robustly and is in the final few years of this economic expansion cycle. The final phase of every economic expansion cycle is marked by increased inflation and higher interest rates.
  2. The Federal Reserve is already on a rate hike cycle! It has no plans to deviate from 3 hikes a year. Even worse, the Fed announced that it will start to unload its $4 trillion balance sheet (most of which consists of long term bonds) starting late-2017. This deluge of bond selling will depress bond prices for years to come.

 You’ll want to slap yourself in the future

Yes, your timing won’t be right. Perhaps rates will fall a little more in the next few months as the “Trump reflation” trade dies down.  But you need to focus on the medium-long term when it comes to the bond market. And the long term says that bonds are the worst investment of all time right now.

Keep in mind that 6-8% is approximately the long term average for Treasury interest rates. When rates inevitably rise to the high single digits, will you pat yourself on the back for buying bonds that yield 2.3%? I hope not! You’ll probably want to kick yourself for being so foolish.

Sure you can convince yourself that “I’m a long term investor”. But let me tell you. If you buy a 30 year Treasury bond at 3% and 4 years later rates are at 9%, that sucks. There is no way to sugar coat it. An investor in the 9% yield is outperforming you by 3 to 1. And when interest rates go up, it means that inflation is up as well. So if your bond yields 3% and inflation is at 5%, you’re losing money in real terms.

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