Mar 20, 2020
So, Are My Bonds OK?
We don’t often field a lot of questions about bond safety, nor would we expect to under normal circumstances. Not surprising nor alarming, signs of stress have crept into the bond market over the past couple of weeks causing bond prices to pull back. While the decline is modest compared to what stocks have been dealing with, this has caught the attention of investors who count on this asset class to provide an important cushion in this difficult environment.
So as not to bury the lead as we explain what is happening, your bonds are clearly okay. Meritage has always taken a conservative approach to investing in bonds by maintaining high quality and short to intermediate maturity characteristics. Typically standing alongside stocks in in a balanced portfolio, we view bonds as providing safety, liquidity, and current income.
Our taxable and tax-exempt bonds have been defensive in this role. YTD declines through Thursday have been in the range of 1% to 3% for the year. Most of the price weakness has occurred in the past two weeks for reasons we discuss below. Most importantly, we know that the outcome of a bond held to maturity of a company that remains in business is getting back 100 cents on the dollar of our investment and earning the rate of return we locked in the day that bond was purchased. Under these expectations, changes in bond prices prior to maturity will have little relevance.
Aside from our U.S. Treasuries holdings, which have no credit risk, investment grade rated corporate bonds and municipal bonds have a very low instance of default. We have limited our holdings to these higher quality bonds and have resisted chasing the higher yields from lower quality bonds and other higher yielding structured investments. While we left some yield on the table in recent years as interest rates declined, staying in our lanes on quality has proven very helpful in the kind of environment we find ourselves in now. Much of the risk in this asset class will be focused on the kind of bonds we have avoided.
What has caused bonds in general to come under pressure the past two weeks? We think there are two primary reasons. The first is simple illiquidity. This happens when fear creates more sellers than buyers as some investors feel the need to move to cash. Forced selling in illiquid markets creates mispriced bonds to the buyer’s advantage. These discounted bond prices will eventually self-correct when the fear subsides.
The other area of pressure is solvency risk. As the potential magnitude of Covid-19’s impact on the economy has become more visible with shut down measures spreading across the country, there has been an increased focus on the quality of a company’s balance sheet. While all companies will be affected by this economic hit, those which are not overleveraged with debt will fare the best.
We have a recent example of what’s going on to help illustrate. The normal spread on a 5-Yr. bond issued by Apple is very tight to the 5-Yr. Treasury yield because Apple is considered one of the highest quality public companies in the marketplace. That spread (difference in yields) has recently been about 50 basis points (earning ½ of 1% more from the Apple bond than a five year Treasury).
Earlier this week we picked up a small block of 5-Yr. Apple bonds trading in excess of 200 basis points (2%) over Treasuries. In this case, the seller of this block was willing to take a very cheap price for their Apple bond in order to move to cash. While good for us as a buyer in this case, the price of this bond and others is marked down by this kind of selling pressure. Again, assuming Apple stays solvent over the next five years, this interim drop in its value means little, as its price will return to par (100) as the maturity date approaches.
From a mechanical point of view, much of this pressure has come from bond mutual funds and ETFs (Exchanged Traded Funds). Sell orders from individual investors require the manager of those mutual funds to sell bonds in order to raise liquidity. In these highly volatile times when liquidity is scarce, large price distortions can broadly occur. This is what we have seen over the past week with the weakness in the lower bond quality areas being among the worst in decades.
These liquidity pressures have impacted the tax-exempt bond market in the same way. Individual investors have pulled record amounts of funds from muni bond funds and ETFs in the last week, causing bond yields to rise and bond values to fall. Again, we should have confidence in good quality municipal bonds providing essential services to communities to come through this difficult cycle in good shape.
Our ongoing job as bond managers in this and any environment is to continually assess the quality of our holdings. As we do that, we will not hesitate to part ways with any particular issue that does not hold up to our criteria. We all understand that the challenges ahead for our economy are unprecedented in many ways and our criteria for holding good quality will be adjusted accordingly. The overriding objective is to keep what is supposed to be the safe side of the portfolio safe.
Next week we will follow-up with another update on the broader markets.