Friday, December 2, 2022

Short Takes: Bond Debacle, FTX Debacle, and more

It’s no secret that bonds got crushed this year as interest rates rose.  Rob Carrick went so far as to say “Given how absurdly low rates were in 2020 and 2021, your adviser should have seen the events of 2022 [the bond crash] coming.”  I agree in the sense that the bond crash was predictable, but its exact timing was not.  I explained the problem with long-term bonds back when there was still time to avoid the losses.

It’s important to be clear that I was not making a bond market prediction.  What was certain was that long-term bonds purchased in 2020 were going to perform very poorly over their lifetimes.  The exact timing of bond losses was not knowable with any certainty.  The tight coupling between interest rates and bond returns is what made it possible to see the brewing problems; this isn’t possible with stocks.

I’ve seen a few attempts by financial advisors to justify their failure to act for their clients by talking about how if you blend poor long-term bond returns with present and future short-term bonds returns, the blend isn’t too bad.  This is like tossing some sawdust into your soup.  The blend may be tolerable, but why include the sawdust?

Many advisors just look at annual bond returns and see their unpredictability as similar to stock returns, but this isn’t true.  Bond yields tell you exactly what average return you’ll get over the life of the bond.  This is true whether you own that bond on its own or blended into a fund.

The bond debacle wasn’t just predictable, it was certain to happen.

Here are my posts for the past two weeks:

When Small Fees Equate to High Interest Rates

Quit: The Power of Knowing When to Walk Away

Here are some short takes and some weekend reading:

Adam M. Grossman clearly explains what happened at FTX and the warning signs that investors ignored.

Jackson, Ling, and Naranjo show “evidence that private equity (PE) fund managers manipulate returns to cater to their investors.”  Some private equity investors get “phony happiness” from “overstated and smoothed interim returns.”

Tom Bradley at Steadyhand was inducted into the Investment Industry of Canada’s Hall of Fame.  His speech reveals what we’ve known about him for a long time: that he cares about his clients.

The Blunt Bean Counter
explains some of the subtleties of the Principal Residence Exemption (PRE).


  1. In fixed income, market timing often means changing your fixed income investments based on your prediction of interest rates. In stocks, market timing often means changing your stock/(bond/cash) allocation, based on your prediction of the direction of stock market returns. In both cases, you're assuming that your prediction is better than the prediction already embedded in prices by all investors as a whole.

    I agree with you that you can relatively accurately predict future returns in investment grade bonds by present yields. I also agree that to a great extent, there's a limit on how low yields can go. If yields go to zero or lower, I'm going to start using a safety deposit box as a substitute for fixed income investing. And with fiat currencies, deflation is much less of an issue. When yields got as low as they recently did, you couldn't predict when the losses would occur. But unless you thought that such low yields are permanent, you could predict that eventually losses would occur.

    About an upper limit on interest rates that could be used for market timing, it probably exists, When real interest rates start to rival historical real equity returns (5-7% range), then one might reasonably make the prediction that interest rates will decrease, although the timing of that decrease will be unknown.

    I agree with you that the low yield problem was more of an issue for longer term bonds. Bond bear markets have a self healing feature. When bond prices go down d/t increases in interest rates (not increased credit risk), those increased interest rates will eventually be to your advantage, and you'll recover. The problem with long term bonds is that the time to recovery won't be short.

    Market timing in stocks is quite different. The vast majority of the time, there is a positive equity risk premium. The times when there is a negative equity risk premium are short. And it's difficult to predict when such periods will start and when they'll end. Stock market returns are much more difficult to predict than bond returns. Valuations have some predictive power over a 5-15 year period, but that predictive ability is limited. There is a self healing feature in stock bear markets, with companies showing reversion to mean in their earnings, but the self healing feature is certainly muted compared to bonds.

    However, I think that stock markets show more manic depressive tendencies than bond markets. Please don't ask me for data to back that statement up, as I don't have any. This uncommonly leads to extremes of valuation, IMO, at valuation extremes, the ability of those valuations to predict market direction increases. For example, there were people predicting the tech wreck in 1999. Jeremy Siegel published an article in the WSJ in 1999 doing that, and Jeremy Siegel is sometimes labelled as a permabull.

    Similarly, there were people predicting stock market returns in the COVID 19 related bear market. The following is from the latest edition of Stocks For The Long Run by Jeremy Siegel:

    "Investors’ fears were real. But was the market reaction rational? Assume the disruptions caused by the pandemic wiped out the profits of each publicly traded company for one year, and by March 2021, with the development of vaccines and therapeutics, profits returned to normal. If a stock is selling for 20 times earnings, (which was approximately the average P/E ratio of the US market before the pandemic hit), then eliminating one year’s earnings should send the price down by only 5 percent, since one year of earnings represents 5 percent of the value of the company. Even if firms went profitless for two years, the drop in stock prices would be 10 percent. I often appeared on media saying the market should fall only between 5 and 10 percent, and the market plunge presented an excellent buying opportunity for long-term investors."

  2. This is just an addendum to what I previously wrote. The focus in stock markets is often on return; stock market investors tend to be somewhat homogeneous in their goals. The focus in fixed income tends to be more on risk. People are using fixed income to manage risk. Since risks vary considerably between people, their goals are more diverse than when investing in the stock market. And the government plays a much greater role in fixed income. Government intervention can distort bond markets. You can make the case that recent low interest rates don't reflect the collective wisdom of the marketplace, but instead reflect government policy. That diversity of goals in bond markets -especially government intervention - can create market timing opportunities.

    About the stock market being more manic depressive than the bond market, I think it might be more accurate to say that the stock market is more volatile. If one considers stocks to have a duration, then bonds are usually of shorter duration. And even though long term bonds are volatile, the interest rate risk of a long term bond decreases with time and it becomes less volatile.

    1. Your analysis could be entirely correct, but I took a simple view that only works in extreme circumstances: the return on long-term bonds held to maturity was so low as to give an unacceptable outcome. This may have meant that long-term bonds were destined to give losses (as they did this year), but even if bond prices just climbed very slowly for 30 years, the returns were still unacceptable.

      It seems plausible that rates were so low because of government manipulation of bond prices (quantitative easing), but even if some people dispute that conclusion, it was still certain that long-term bonds held to maturity would give unacceptable returns.

    2. Glad I don’t have “Long term” bonds in my portfolio, based on your comments. I do have “Medium” term bonds though. What is your assessment of those? Is there a better alternative for us retirees out there?Thanks.

    3. Back in 2020, I only owned short-term bonds and had cash in high-interest savings accounts. However, conditions have changed now that bond prices have dropped. I still choose to avoid medium- and long-term bonds, but I don't think there is anything wrong with others making a different choice.

  3. Hi Michael - I've been trying to understand bonds properly. Is it true that Yield to Maturity (YTM) is the most important element for evaluating total return? For example, VSB (short term bonds) YTM is 4.2% and ~2.7 years maturity. Per my understanding, this means I will earn 4.2% annually if I hold VSB for 2.7 years.

    Whereas, ZAG (mid-long term bonds) is at 3.6% YTM with ~7-8 years maturity. Why hold ZAG right when you can own VSB? Unless you want to guarantee 3.6% annual gains for the next 7-8 years.

    Thanks so much for your feedback Michael. Also, I am 33 years old and I'd love to grab coffee/chat with you for 30 mins if you ever have time. I am not sure if this is feasible but you've made an impact on me for the last number of years.

    1. Anonymous,

      Right now, the bond yield is inverted, which means that longer term bonds yield less than shorter term bonds. This is because the collective belief of the bond market is that short term rates will decline in the future. There is no guarantee that this will actually happen, but that's what the market "thinks".

      If the market is right, VSB will pay more than ZAG will for a while, but as VSB rolls over matured bonds, its return will decline. Again, there is no guarantee that this will actually happen.

      I'm happy to meet readers to socialize and to discuss financial matters in general, but I'm not a financial advisor.