On March 5th, I wrote about fixed income being the bubble that should be most concerning to the investor: The Bubble to be Worried About. Since that time, bonds across the globe have been falling in value, causing significant losses in many fixed income portfolios. The 10-year Treasury bond traded as low as 1.68% earlier in the year and the yield has now traded as high as 2.36% early this morning. The German 10-year Bunds were showing negative rates earlier in the year and have now traded around 0.7%. There moves in bonds are not necessarily related to any significant change in economic growth prospects, as the data really hasn’t been that great. The reality though is that the recent interest rate environment is not sustainable. It is reflective of incredibly negative perceptions on global growth prospects and the massive quantitative easing measures that are being taken to stimulate growth, in lieu of an appropriate political response.
These interest rate moves are significant, but are just the tip of the iceberg of how things can possibly move from here. If we were to get to a 4-5% yield on the 10-year at some point in the future, the carnage on fixed income portfolios would be considerable. As I described in my previous article, many companies have wisely taken advantage of these low rates to make acquisitions or to engage in some sort of financial engineering such as buying back stock. These activities have been well regarded by the market as can be seen from the very high multiples given to companies in active merger industries such as healthcare. Higher rates will make it much harder to engage in these types of activities. Debt will become much more costly and future problems can become more highly magnified due to the rise in leverage. It seems very rational to me that we might see the economy actually get a bit better than it has been, but still see bond and equity markets see flat to negative performance.
With this in mind, at T&T Capital Management (TTCM) we are positioned in areas that will benefit from higher interest rates, such as financials. Banks and insurance companies will see radically improved margins when higher rates do come and earnings growth should accelerate. This combined with the efficiency gains made through navigating this downturn should lead to stellar investment results. Many market participants have piled into “blue chip” or utility-like stocks to chase yield in this low interest rate environment. This crowded trade will likely lead to considerable permanent losses of capital as rates rise and valuations retrace towards historical means. We have circumvented that from using our strategy of selling cash-secured puts on undervalued companies to generate attractive income streams, while taking the risk of owning stocks that we want to own at cheaper prices than what can be procured through buying the stocks at current prices. This provides a nice layer of protection upon a market downturn and should help us in most environments.
We could very well see a lot of volatility in both bonds, stocks and currencies while these changes are taking place in the marketplace. The key is focusing on the individual businesses and paying the right price for them. We can do well in any interest rate environment, as we have bought securities at large discount to intrinsic value. Quarter by quarter, our key positions are growing their intrinsic values and ultimately our investment performance will reflect the business results of the underlying businesses. I’d urge caution on chasing yield or using leveraged ETFs, as I believe this is just a preview of what can come in the future when rates do become less manipulated by the Central Banks.
Please feel free to give us a call if you have any questions or thoughts whatsoever!