Bonds

Investing in the face of a War and High Oil Prices

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Quiz!

What are ways to make money by staying out of the stock market for now?

  1. Move to cash until getting clarity about Iran in the near term.
  2. Move to US stocks that are perceived as a safe-haven for now.
  3. Move to cash for as long as it takes, until a resolution for the war is in sight.
  4. Move to bonds for safety.

Investing in the face of a War and High Oil Prices

Oil prices jumped over 50% in two months given the war in Iran, which borders the Strait of Hormuz – the biggest passage of oil for the world. Higher oil prices are inflationary, since they affect the price of gas for travel and shipping, heating oil, plastics including food packaging, fertilizers for food and more. The concern is that a rapid spike in inflation may lead to a global recession. One question is whether it is safer to invest for growth beyond inflation, or keep money not invested with the hope of buying lower. Here is what it would take for a successful bet on staying out of the market:

  1. The war continues with no signs of a potential improvement in passage of ships in the Strait, and you reinvest when uncertainty is higher, or
  1. The uncertainty continues for a very long time, with a spike in inflation hurting the economy. You invest when there is more clarity, but the economic damage is big, making the declines bigger than the gains thanks to the clarity.

Here are things that could lead to a missed opportunity:

  1. You keep money on the sidelines, and reinvest when there is clarity in the near term. When you see real clarity, big investment gains are likely to be behind us.
  1. There is some resolution before serious economic damage. So far, there are at least 30 countries committed to helping open the Strait. There are various paths to success, including one-sidedly stopping the attacks in Iran.
  1. Value stocks outside the US are priced around average, when considering inflationary forces that tend to increase the steady-state valuations (as measured by Price/Book or P/B). Avoiding holding them is very different from US Large Growth stocks that are priced extremely high – potentially higher than any other time since 1929.

At this point, it is impossible to be certain that one approach is better than the other. There may be more factors beyond those presented in the article. Please don’t use this information as personalized investment advice.

Quiz Answer:

What are ways to make money by staying out of the stock market for now?

  1. Move to cash until getting clarity about Iran in the near term.
  2. Move to US stocks that are perceived as a safe haven for now.
  3. Move to cash for as long as it takes, until a resolution for the war is in sight.
  4. Move to bonds for safety.

None of the answers is correct.

Explanation:

  1. Once we have real clarity about Iran, we would likely have big gains behind us. If this happens in the near-term it is likely to offset declines leading to it.
  2. While US stocks are often perceived as a safe haven at times of uncertainty, their extremely high valuations may more than offset the benefit. In addition, the reversal for non-US stocks is likely to be significantly steeper, given the combination of lower valuations and higher growth.
  3. This could work if there is a long path to a resolution of the war, and the economic damage is big enough to offset the spike in stocks due to more clarity. Given the risk of high oil prices, the world is more likely to find a resolution before letting the damage build up, so it may be a risky bet.
  4. Bonds do poorly when inflation goes up and interest rates may increase to fight the inflation. While economic damage typically leads to lower interest rates, when having to choose between fighting inflation vs. a recession, the choice is likely to be skewed towards fighting inflation, because high inflation can worsen a recession. In addition, in case of a resolution of the war before sustained economic damage, you could miss a surge in stocks.
Disclosures

What are Some Pitfalls of Bonds Today, and When will they Subside?

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Quiz!

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility.
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long -term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

What are Some Pitfalls of Bonds Today, and When will they Subside?

Bonds offer much higher interest payments these days compared to 2 years ago. They are appealing for various uses. They are especially useful if you prefer/need to moderate the volatility of stocks. When deciding on a bond allocation, it is worth paying attention to the following pitfalls:

  1. Short-term bonds: After inflation and taxes, it is tough to get substantial income, and often the net real income is negative. For example, a bond paying 4%, to a person with 25% income tax rate, nets 3% income. With inflation of 4%, this leads to a -1% return. Tax-free municipal bonds address the tax penalty, but at a price of lower income, that also faces the inflation headwind. It is not a reason to avoid using them, but important to be aware of the issues when deciding on the allocation.
  1. Long-term bonds: Long-term bonds sometimes (not always) enjoy higher income but face an additional problem: the risk of rising interest rates. Historically, once inflation reached a 9% level, as happened last year, it took a median of 10 years to go back to normal.  So, without any bad luck, the bond becomes a risky investment for extended periods. The price of a 20-year bond paying 4% per year changes by 13% for every 1% change in interest rate. Compounding the declines for a 4% rate increase causes about a 40% decline. If you hold the bond to maturity you avoid the interest rate risk, but still have inflation risk. In addition, there are more compelling investments for long-term holding periods.

When would the risk of long-term bonds go down. Once Core PCE inflation (the measure that the Fed tracks) gets closer to 2%, the Fed may feel confident enough that it completed addressing the high inflation, and will more likely stop raising interest rates. While there are many factors affecting interest rate decisions, this is a prominent risk factor for bondholders.

Note that this article only pointed out a couple of risks of bonds today and is far from a comprehensive review of bonds. There are many types of bonds that are appropriate for different uses at different times.

Quiz Answer:

Which of the following statements are true? (There may be multiple answers.)

  1. Short-term bonds are attractive today, given their high interest payments.
  2. Short-term bonds are appealing whenever there is a large upcoming expense.
  3. Short-term bonds enjoy low volatility. [Correct Answer]
  4. Long-term bonds are attractive today, given their high interest payments.
  5. Long-term bonds are appealing whenever there is a large upcoming expense.
  6. Long-term bonds enjoy low volatility.

Explanations:

  1. While high interest payments are more appealing than low interest payments, you need interest payments materially above inflation to give appealing after-tax growth or income. Other investments can do this job better.
  2. Not knowing anything else, this statement is true: short-term bonds are appealing when there is a large upcoming expense. There is an important exception to this statement: when the total withdrawal rate (including the unusual expense) is low enough, it is possible to enjoy the benefit of stocks while supporting the unusual expense, as long as the investor is perfectly disciplined. Some large expenses can be broken down to a series of smaller expenses, alleviating the need for bonds. Examples are student loans and mortgages.
  3. Correct: Short-term bonds indeed enjoy low volatility.
  4. Long-term bonds seem attractive today, given their high interest payments, but they can decline in the face of rising interest rates.
  5. Long-term bonds are not appealing for large upcoming expenses. They can decline significantly in the face of rising interest rates, as seen in 2022.
  6. Long-term bonds fluctuate a lot more than short-term bonds with changes in interest rates. They have lower volatility than stocks, but not always low volatility.
Disclosures