Stocks, Bonds & Optimism

Years ago, in the middle of the raging bull market of the late 1990s, I taught a bond class in SMU’s continuing education program.  One notable feature I highlighted in the class was how bond performance had matched stock performance since the beginning of the bull market in the early 1980s.

The class stressed bond market performance because few investors seemed to.  Instead of performance bond investors tended to focus on yield.  But in the giddy days of the late 1990s NASDAQ market, the excitement was about DELL and dot-coms and bonds quite simply had no rocket ship to the moon.

One thing I did not point out in the class was the explosion in the amount of bonds (or debt) outstanding.  We are taught that more demand usually leads to higher prices; we are not taught that it is Wall Street that creates the supply to meet the demand.  And create bonds Wall Street did!

We understand that when interest rates peaked in the early 1980s, bond prices bottomed.  The bear market for bonds ended and the bull market for bonds began.  Lower interest rates on long-term bonds provided the performance for bonds to match stocks, almost in eerie fashion for over fifteen years.

Yet it is the amount of debt created, the exponential, hockey stick-shaped supply over the past thirty years that is just as unbelievable.  Tremendous demand could certainly explain bonds tremendous thirty year performance.  But together with a staggering amount of supply?  Should this supply not affect performance as well?  The answer, so far, appears to be no.

So what is behind the staggering demand, together with the staggering supply, that has led to the tremendous performance in bonds these past thirty years?  I believe it is the same thing that drives the stock market: optimism, and a tremendous amount of it.

Years ago when we were much younger, debt was something you went into and later paid back.  This assumption, occasionally became fact, such as during the Texas energy and later real estate crisis when banks assumed (wrongly) that borrowers would pay them back and later demanded that those borrowers who could, must.  But that was twenty-plus years ago.  Since that time we have all learned that the best way to deal with a debt crisis is to issue MORE debt.  The same conditioning continues today.

Once upon a time corporations carried a small percentage of debt on their balance sheet.  Small became more and more became even more so that by the end of the 1990s almost all public companies carried significantly more debt than they had fifteen years earlier.  But we hadn’t seen anything yet.  With the lowest rates (ever) in the post financial crisis years, seemingly any corporation that could borrow more has done so.

The demand for bonds was strong so Wall Street served its role by creating the bonds and adding supply.  But again, what makes this possible?  Optimism.

We experienced (and continue to experience) the lowest interest rates in the history of our country.  Never before have interest rates been lower and, as you know, bond prices higher.  And never before have we had so many bonds outstanding.  We must be THAT optimistic!

This is not our first foray into investments.  We have all been tempered by past crisis: 1970s bear market, Texas oil/real estate crisis, NASDAQ crash, the financial crisis.  In each one optimism just…disappeared.

Today, not only do we have optimism, but we have the greatest optimism ever, enough to produce the lowest interest rates and the highest stock and bond prices…ever.  Yet it almost seems…normal.  Did you realize the extent of the optimism?

The waves of optimism does not dissipate evenly in the markets.  I continue to point out that all asset classes, with the tremendously notable exception of stocks, have already peaked in price – some years ago.  These are the warning signs that optimism does not continue indefinitely.  This time is NOT different.

What is different this time however is the amount of optimism, as evidenced by the tremendous amount of debt and the all-time high prices of the debt.  This is extraordinary and, as such, I expect extraordinary happenings to occur in the bond markets.  When previous crisis have hit, bond markets have seized up for days, weeks, even months.  All-time highs may indicate an all-time response and repercussions.

Optimism is the driving force in financial markets, municipal bonds included, and currently the best place to watch this play out is in the bonds of Puerto Rico.  Puerto Rican bonds have been a favorite of money managers looking for double and triple-tax exempt bonds to diversify their own state holdings.  New York City residents can buy triple-tax exempt (free from local, state and federal taxes) New York City issues or they could also buy Puerto Rico bonds.  Puerto Rico has tens of billions of dollars in bonds outstanding (a staggering amount indicative of staggering supply and previously staggering optimism) hence Wall Street also loves them as they have provided hundreds of millions of dollars in fees through the years.

There was no rhyme or reason why Puerto Rico debt suddenly stumbled last summer, but obviously optimism…disappeared.  The situation demanded action, and as you know, the response to a debt crisis is currently (we are still optimistic!) more debt.  With Wall Street selling more debt (to meet investors demand for more Puerto Rico bonds at high yields), the situation moderated.

Here we are just a few months since Puerto Rico’s last bond sale and prices (optimism) has plunged again.  Mutual funds and money managers that previously had AAA insured Puerto Rico bonds (before the financial crisis) or investment grade Puerto Rico bonds last year, now have huge non-rated or junk-rated positions of Puerto Rico bonds to contend with.  One day the greatest optimism ever; next day not so much.

Optimism is nice while you have it.  I have seen many occasions where seemingly optimism alone was responsible for paying back bonds, most notably when junk or failing bonds are refinanced by new bonds.  But I do not count on optimism to pay back the bonds we buy.  The reason is simple:  optimism can and does disappear, sometimes when you least expect it.