Return-Free Risk - Bellwood Capital

When you think of government bonds and their role in your investment portfolio, you typically think of stability. You invest in the stock market for high returns, but the bond market for stability. Bonds are there to ‘reduce the risk’ of your investment portfolio, and for that many are willing to accept lower returns. This paradigm has failed investors miserably in the last 3 years as interest rates globally have been hiked at record pace.

According to Bloomberg, US 10 Year Treasury Notes have crashed 46% since March 2020. That’s on par with the worst stock market crashes since the Great Depression! In the last century, US treasuries have never delivered more than 2 consecutive years of negative returns, and even then never of the magnitude witnessed since 2020. This truly is an historic market crash. What makes it even more incredible is that no-one outside of the investment industry seems to be talking about it. If it was the stock market or real estate it would be front-page news by now. I say this tongue-in-cheek, but it’s somewhat refreshing for an equity portfolio manager to watch a market crash from the sidelines.

Risk ≠ Return

There is an important lesson to be learned here. It doesn’t matter how high the quality of an asset is, how consistent the cash flows are, or how creditworthy the issuer may be – if the price you pay becomes completely detached from reality, then the asset becomes very risky. What’s worse is that this risk is associated with low returns, even under optimistic conditions. This stands in contradiction to the common (and inaccurate) mantra that risk = return. Higher business risk may typically be associated with higher potential returns, but the higher risk that comes from overpricing an asset is always associated with lower return.

Consider that in 2020, 10 Year Treasuries were yielding just 0.5% p.a. At that yield you’re not thinking about return, you’re all-in for downside protection. Ironic that 3 years later you’ve lost 46% with virtually no interest payments to cushion the blow, while the stock market (which you were fleeing) has climbed ~80%. One of the reasons Treasuries have never done so badly before, even though they’ve been through some extreme rate hiking scenarios, is that interest rates were already high enough in past hiking cycles to offset most of the capital losses. What you lost in capital you gained in interest. Not so when interest rates are close to zero. Can you see how this crash was built into the price?

Implications for the Stock Market

So what does this mean for the stock market? It’s not entirely clear since stocks are affected by many variables besides interest rates. Unlike bonds, future cash flows are not fixed. Higher inflation means higher revenues for companies, but it also means higher expenses, higher financing costs and, at least in theory, lower valuations. I say in theory, because it may also just mean that the relationship between bond yields and stock market earnings yields (the inverse of Price/Earnings Ratio) have finally normalized after more than a decade of being disconnected. We’re used to thinking of stock market valuations in terms of PE ratios and bonds in terms of yields. If I told you the S&P 500 would trade at a PE Ratio of 200x (more than 10 times historic norms), you’d think I was crazy, yet that’s the equivalent of what US Treasuries were doing in 2020. Just because bond yields have normalized from insane levels doesn’t automatically mean that stock market valuations must drop too.

We are beginning to see the effects of more than a decade of extremely loose monetary policy unwind. What has caught so many off-guard is how quickly loose monetary policy has unwound. We saw signs of the inevitable strain in the first quarter of 2023 with the US Regional Banking Crisis. Now we’re seeing it in the longer dated government bond markets across the developed world. Such a drastic change, to something as fundamental as interest rates, cannot take place without the ripple effects being felt throughout the global economy.

For us as equity portfolio managers, we continue to avoid over-indebted and over-valued stocks, which are most sensitive to fallout from higher interest rates. The biggest risks to be avoided in every kind of investment portfolio are always those that come from excessive leverage and extreme overpricing. Investors may have been willing to overlook these risks in zero-interest rate world, but we believe that’s likely to change.