The Bond-Zombie Apocalypse
September 24, 2014 by Frank Maselli
It’s often said that experience is the best teacher. But if you can learn from someone else’s experience, the tuition is often a lot cheaper, and in this case, far less agonizing. So, allow me to share a horror story with you. We are now facing an economic situation similar to what we saw 20 years ago, and I know from experience that you’re not going to like what’s about to happen to you and your clients.
The year was 1995 and certificates of deposit (CDs) were paying a paltry four percent, with money markets delivering even less. Investors were sick of these low rates and every advisor was looking for income alternatives. Sound familiar so far?
Of course, today we’d kill for a four-percent return, but remember, back then we were just off the heels of the 1980s, when rates had been in the double digits. Folks were used to getting 14 percent and 15 percent on govies and 10 percent on tax-free munis, so we were all starved for yield.
To fill this void, Wall Street launched dozens of short-term bond funds. My firm raised billions with our infamous “CD Buster” sales campaign. Our portfolio manager was hailed as the second coming and she guaranteed the fund would be “rock-solid” with a “flat line” NAV akin to a money market. She claimed that they “stress tested” the fund and no matter what rates did, it wouldn’t change more than four cents per year on an initial offering of $2.50.
The secret of her wizardry was the portfolio of short-term bonds. Our fund had a duration of 0.2 years and was all in AAA-rated paper, but the yield was targeted at 5.5 percent — a dramatic improvement over anything else in the marketplace.
OK, you’re getting the picture. I’m giving you all of this detail because I want you to imagine what it might have been like to sell the living crap out of this fund. We told our best advisors to bet the farm and put their top clients in this fund — and they did. How could they not? Everyone was doing it, and even if the spaghetti hit the fan, the extremely short-duration and high credit quality of the bonds would protect us. I mean, 0.2 is pretty darn safe.
So we launched the fund amid much fanfare and excitement. It was the largest raise-up in company history.
Exactly two weeks later, the Fed raised rates by 25 basis points and we all watched with nervous anticipation. The fund began to waiver… $2.49, $2.48, $2.47; damn — we had just dropped three cents out of the promised 4-cent maximum decline in three days. That wasn’t good.
Then bang; we hit the iceberg — $2.40 — a 10-cent drop! Instead of the four-cent, stress-tested drop in one year, we’d plunged 10 cents in three weeks!
We were all stunned. I was in charge of all mutual fund sales for the New York metropolitan region and my best advisors were lining up to shoot me. So I made a fateful decision. I spread the word to all my advisors as fast as I could, telling them to get out of the fund.
Naturally, they had some questions and shouted, “Whaddya mean, ‘Get out?’ We just got in!”
“I know,” I replied, “but I’m telling you to get out right now! The portfolio manager has lost control. Her models didn’t work and she doesn’t know what’s going on!”
Long story short, the fund dropped 42 cents in seven weeks. Every firm in the industry was sued and had to write huge class-action checks. The advisors who stayed in the fund got hammered and they learned a brutal lesson: Losing a client’s money in stocks is one thing, but it’s a whole different level of pain to kill them in bonds.
So why am I telling you this story?
Folks, the Fed has been warning us for a couple of years now that they are going to raise rates. Everyone knows this is coming. However, a sizeable number of advisors seem to think they’re safe in some kind of short-term, laddered bond portfolio with inverse hedges and long-short capability. But they’re not safe. They’re going to get hurt badly, and they may not be able to sustain another body blow to their client relationships.
So if you absolutely need to be in some kind of guaranteed instrument, I recommend you find a strong insurance company with a reasonable fixed-rate annuity. Pass the potential risk of this asset class to professionals who can sustain it with a longer term perspective and other assets to offset the liability.
When rates do go up and the bond-zombie apocalypse hits, you will be safe in your shelter and very glad that you read this article. And at last, I will be redeemed.