Doug Kass was featured in this weekend’s Barrons and offered some interesting reasons for his long-term bearish view on bonds. He calls this his “favorite short of the next decade”. The 8 reasons for his bearishness (some of which I obviously disagree with): expensive, poor after tax-yield, weak economic growth, Fed policy, higher inflation inflation, housing recovery, asset reallocation from bonds to stocks, bond vigilantes attacking unsustainable fiscal situation (via Barrons):
“Finally, my favorite short of the next decade is the U.S. bond market, for those that possess deep enough pockets, have the fortitude and the patience. I am long ProShares UltraShort 20+ Year Treasury [TBT], which is the inverse, double-short bond ETF. Over the past 2½ years, bonds have achieved a near 60% total return. A remarkable feature is the consistency of positive returns and the absence of many drawdown years of consequence. Nevertheless, they should be viewed as a return-free asset class that is very risky. The 10-year yields under 1.5%, less than half the yield during the recessions in 2001 and 2008. That means I am paying over 65 times earnings for a 10-year-bond, a rich price even by Amazon’s or LinkedIn’s standards.
A taxable investor who buys the 10-year pays about 40% to Uncle Sam in taxes. So his after-tax yield is 0.9%. The inflation rate is 2%. So the investor is getting a rather large negative return. A diminution of the flight to safety is a first possible disruptive factor.
Other factors that form the basis for my bond short are that the muddle-through economy might gain speed, that Fed policy stays on hold, that inflation will ultimately rise, that housing is embarking on a durable recovery, that ultimately there will be a large reallocation of investment out of bonds into stocks, and that U.S. fiscal imbalances are not being addressed, so bond vigilantes who will demand higher yields are likely to appear.”
This sounds an awful lot like some of the bubble calls I’ve been calling nonsense for years now. But I have to admit that some of the concerns are warranted. So how does one combat this fear? First, you have to understand the place for bonds in a portfolio. Bonds are a hedge of sorts. They should never comprise the core position of a portfolio. So, if you’re concerned about many of the concerns that Kass mentions and you’re properly allocated around a core equity position then your equity gains should outpace your bond losses by a healthy margin. But perhaps more importantly, if you’re heavily invested in bonds you need to better understand how to build a global bond portfolio and a well diversified bond portfolio through laddering (see here for more info).