Debt Trap

Risk is defined as being exposed to danger. Financially, debt is a source of danger. It can be a trap. Escalating borrowings to pay for spending that is not covered by income may eventually lead to an unmanageable debt repayment burden. During the financial crisis of 2007-2009, at-risk private corporate debt was transferred onto the federal government’s balance sheet as a way to keep major financial institutions and the free market system operational. Federal government debt exploded higher, from roughly $9 trillion in 2007 to $19 trillion today. The ratings agencies downgraded the U.S. federal government credit rating for the first time in history in 2011.

Something that looks dangerous and is dangerous is not as dangerous as something that looks safe but is dangerous.

Unsafe situations that are hidden are truly dangerous as we let our guard down and become exposed to the danger. Stocks are commonly thought of as risky, especially in the short-term. Bonds are often considered safe. Safe and unsafe in the investment world is often measured by volatility, especially downside volatility. If an investment can lose a lot of value, it is not safe. Bonds are supposed to be a relatively “safe” asset. As investors age, the advice of many money managers is to shift away from stocks and more to bonds as a way to de-risk one’s portfolio.

With Baby Boomers retiring and with many stock investors feeling pessimistic about world events, money has been flowing out of stocks and into bonds. Through August, $53 billion had been withdrawn from U.S. equities while $220 billion was invested in taxable and tax-free bonds. Trying to hide in the “safety” of bonds may be a dangerous trap.

Below is a chart of fixed income (bond) volatility relative to equity (stock) volatility.

We can make a few observations:

1. Fixed income and equity volatility had a strong correlation through October.

2. Fixed income volatility was often higher.

3. Fixed income/bond/the safer investment has become far more volatile than the “dangerous” equity investment in the past couple of months.

Over the past five months, 20-year U.S. Treasuries (TLT) have declined 16.5% and the US Aggregate Bond Index (AGG) -3.6% while the S&P 500 (SPY) has gained 6.5%. Gold (GLD) has fallen 14.3%. A large portion of the separation has been since the election.

From 1981 until July 2016, bonds did provide good returns and a safety trade. That is because interest rates trended down on a secular basis during those 35 years. When interest rates decline, bond values rise – and vice versa. Corporate bonds had a positive real annual return of 6.6% during the 35 years of declining rates from 1981 to 2016. Before interest rates declined for 35 years, they rose for 23 years. From 1958 to 1981, the 10-year U.S. Treasury rate climbed from below 3% to 15.8%. The annual real return (adjusted for inflation) on corporate bonds was negative -2.0%.

Mega-trends in interest rates last for decades. Rates climbed for 23 years and then declined for 35 years. It appears they are climbing again. With U.S. government debt at 77% of GDP (some estimates have it as high as 104% of GDP), rates may rise for several decades as the highly levered U.S. government has to continue to attract new buyers for trillions worth of new treasury issuance. In an economy that is experiencing accelerating growth, the trade that has traditionally been viewed as risky may be the safest place to be. Corporate balance sheets are in great shape. Conversely, the federal government has taken on a huge debt load and interest rates are rising. Risk, in the form of debt, was transferred from the private sector to the public sector during the credit crisis. If debt is the measure, stocks look safer than bonds currently. Avoiding the debt trap could be a driver of stock appreciation for years to come.

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