Bonds—Ladder or Fund? TIPS or Nah?

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks. Hi, this is Jack Howe, and this is the Barron's StreetWise Podcast. Welcome. With me is our audio producer Jackson. Hi, Jackson. Yo. That's— I'm trying different things. That's your new— you thought that that would come across what? I can't say the same thing every way. Just kind of casual. I thought you were going for like tough and cool. It sounded like kind of like Arthur Fonzarelli, if you remember that. But okay, look, go with yo. And you know, I think it's working for you. Now I am away this week and hold on. Whoa, whoa. Don't panic. I see out there. You're panicking. You're thinking I'm going to leave you high and dry. With no episode, you're thinking we're going to hit you with a rerun or something like that. I wouldn't do that to you. I mean, I would do that to you, probably have done it, will do again several times a year. But I'm not doing it to you this week because we've got a great conversation with Cathie Jones over at Schwab. She's the bond expert at Schwab. She's going to talk to you about everything you could possibly want to know about what to do about bonds now. Is it still a good time to buy? How should you feel about corporate bonds relative to Treasuries? What about junk bonds, munis, TIPS? How far out should you go on the yield curve? What about the decision of whether to buy individual bonds versus bond funds? All your questions will be answered. It'll be like paradise for the fixed income curious. I'm overselling, but Kathy is always informative. And I can hear one or two of you are saying, well, I'm not fixed income curious, thank you very much. I wanted to hear about stocks. So boohoo. Well, I've got you covered too, because even though I'm away, I'm going to say a few quick words about the stock market right now. Please don't call me a hero. Jackson, my stock market music, please. Look, I just want to give you a couple of bullets from our friend Savita Subramanian over at B of A Securities. Everyone's question right now with the U.S. market hitting new highs is, can it move higher from here? Are we due for a fall? The stock market looks expensive, historically speaking. And BofA points out, as it says, it is egregiously expensive versus history based on 20 different measures of valuation that it follows. Things like the trailing PE, the forward consensus PE, the Shiller PE, the price-to-book value ratio, price-to-free cash flow, EV-to-sales, and so on. It says 19 of those 20 metrics show that the market is expensive. Based on trailing price earnings ratio going back to 1900, the market is trading at the 95th percentile. Statistically speaking, pretty darn expensive. So it's natural for investors to wonder, is it due for a tumble? Today's valuation is actually a pretty poor predictor of whether the market will tumble in the near term. It's a pretty good predictor of what your average returns might look like over the coming decade. And B of A says that their statistical models point to returns averaging 3% a year over the coming decade for the US stock market. That's quite low. But it says that if you're wondering what the market might do in the next 3 to 12 months, better predictors might be things like sentiment and surprises for earnings and growth. And those have been positive. B of A says be careful comparing today's stock market to the markets in the '80s, '90s, 2010s. It points out that leverage for the S&P 500 has fallen by half over time. Companies today tend to be higher quality and have lower earnings volatility. The index used to be dominated dominated by asset-intensive companies in the manufacturing industry, also financials and real estate. But today, about half of the index is comprised of asset-light companies in tech and healthcare. So if investors are paying more for today's stock market, maybe they should. Maybe it's a better stock market. There's a lot of highfalutin stuff in here about equity risk premium, about how it could rise for the Magnificent Seven tech companies in the index and how it could fall for the remaining 493. There's a line in here that goes, brace for big words— we found that a log-linear trend line applied to an earnings time series yields a more accurate normalized earnings forecast than other mathematical methods like Shiller's, etc. Uh, I'll just tell you that basically what they're saying is that although those Magnificent Seven companies look expensive and maybe the valuations for those could come down, there's also the possibility that the valuations for the other 493 companies could rise. And for people who are wondering Are earnings today too high because they look high historically speaking? Are they due to revert to lower levels? B of A says a better thing to look at is just the trend line of what's going on with earnings, because it's possible that earnings have structurally shifted higher for the market. They say our base case is that normalized earnings are unlikely to plummet from current levels, assuming no hard landing and near-peak Fed fund rates. Encouragingly, earnings and GDP growth have positively surprised in recent quarters. They take all this to mean that fair value for the S&P 500 is around 5,500. That is 8% higher from recent levels. Put it all together. They don't expect the market to plunge. They do expect the market to rise in the near term. They also expect long-term returns for US stocks to be below what we have come to expect. And that is enough for now. About stocks and probably forever about the equity risk premium and log linear trend lines. Sorry, log linear fans.

I'll have to cancel my Logging On with Jackson spinoff podcast.

It was just getting off the ground. And with that, it's time to get to my conversation about bonds with Cathie Jones at Schwab. Let's listen. I mean, I don't have to tell you, let's listen. You're already listening. Keep doing what you're doing. You're fine. You're doing great. Kathy, what do we make of this bond market? We started the year, what, just below 4% on the 10-year yield. There might be people out there that were thinking, darn it, I meant to lock in some bond yields here and I've missed my chance. And now we've got a high-ish or higher than expected reading on inflation. And bond yields have backed up a bit. What do you expect for the rest of the year? Or how long will the getting be good on these yields?

Yeah, it has been, Jack, quite a roller coaster this year. You know, we ran all the way up to 5.02 on the 10-year Treasury and fell back to 3.80-something, and now we're about 4.25. You know, our view is that the overall trend in yields will continue to be lower in the second half of the year. We do expect the Fed to lower rates because inflation's coming down, but that's going to be a bumpy ride too. It's not going to be a smooth path. And, you know, we really expect the yield curve to what we call bull steepen. So overall rates down, but short-term rates down more than intermediate and long-term rates as the yield curve sort of normalizes from being inverted to flat to un-inverted towards the end of the year. We have 10-year yield fair value around 3.80 or so, but there's a wide range around that. At these levels, at 4.25 up to 4.30 on the 10-year, we think there's value for investors looking to lock in some yield for the future.

Okay. Bull steepen, steepen meaning the long end of the curve will be higher rates than the short end or comparatively higher. Can I take the bull and bull steepening to mean It's something good. Is it a good sign?

Yeah, it should mean lower rates across the yield curve in Treasury. So, um, that's the good news, but much more probably for, you know, 1-year, 2-year, out to 5-year bonds than, say, for 7- to 10-year bonds that have already priced in a lot of Fed easing at this stage of the game. But the other interesting thing is we talk about the yield curve like there's one yield curve. There's lots of yield curves. And in the corporate bond market, the yield curve is actually flat or upward sloping, which means if you do go out further in maturity as you invest in investment-grade corporate bonds, you actually get a little bit more yield. That yield curve is very different than the Treasury yield curve right now.

I see, because someone might look at that Treasury yield curve and they might say, wait a second, on the very short end there, there's— I see yields around 5.5% and maybe that's sort of a proxy for what people could find in a money market, or they could find maybe 5% plus somewhere out there in a money market. So they might be saying to themselves, why should I lock in a 10-year Treasury paying 4.3% if I can get 5% in this liquid money market? But in your view, all these yields are going to come down later in the year. So you might be quite happy that you locked in that 4.3% if those money market yields on the short end of the curve move meaningfully lower. Are we talking like multiple percentage points lower from here?

Well, not in 2024. We're probably looking at 75 to 100 basis points. So, you know, that's still meaningfully lower. That's pretty significant. And when you look at what the Fed's projecting, I mean, they have a longer-run estimate for where they're going on short-term rates on Fed funds down to 2.5. It could take a long time to get there. We may not get there, but the direction of travel is expected to be lower. So if you stay very short-term, then you have reinvestment risk, right? So, once their T-bill or your money market fund starts to move down, you know, you're investing at lower and lower yields, which is why we think it makes sense to lock in some of the intermediate duration bonds right now, just because you can, with some certainty, then say, okay, we know what cash flow we're gonna get over the next 5 to 7 to 10 years.

Is there anything— there's nothing really then that we should take away from that inflation reading? I mean, we began the year thinking, okay, yields are moving lower, then they backed up, but you're still saying they're going to move lower. Was that just an economic hiccup? What happened there? Does it matter or can we just ignore that for the long term?

Well, I mean, you can't ignore anything, but we don't think that the new trend in inflation is higher. It's going to bounce around as it does from month to month. And we're super sensitive right now in the market to any little squiggle., that doesn't meet expectations. But at the end of the day, much of that was driven by this owner's equivalent rent or the housing cost, uh, measure that they use in CPI. That's kind of unusual. It's a big proportion of CPI, and the way it's done is kind of not very intuitive. So when we look at real life rents, they're coming down. Those housing costs are coming down, and that's what goes into the, the inflation measure that the Fed uses, the personal consumption expenditures deflator, that probably will show less and less inflation pressure as we go forward. So we're still pretty optimistic that the inflation trend is down, not sharply down, not evenly down, but still trending lower.

Where are the good deals in bonds and where are the bad deals in bonds? If we were to compare, for example, you mentioned high-grade corporate bonds. If we were to compare those with Treasuries, and then if we were to compare high yield or junk bonds with Treasuries, What are those? How relatively attractive are those two areas?

Yeah, great question. So the spread, as we refer to it, the yield difference between Treasuries and, say, investment-grade corporate bonds and high-yield bonds, they're relatively low compared to history. But the absolute yield in investment-grade corporate bonds is above 5%, which most people find pretty attractive. And those spreads are low for a reason. Because a lot of the investment grade, you know, the bigger companies with stronger balance sheets, more cash flow, they have locked in low borrowing costs for years. So, their balance sheets are in good shape. And that's why there's not a bigger yield premium in that market because it looks pretty steady going forward. Junk bonds, a different story. Those spreads are very, very low as well. We're a little bit more cautious there because by nature, these are going to be smaller companies. With more leverage, more challenging financing that has to be done, but the yields are very high. And so, not relative to Treasuries so much, but they're high in nominal terms. So, investors find them attractive, but we'd be a little bit more cautious there because if we were, say, to get into an economic downturn, run into some trouble in certain sectors of the economy, the junk bond market would be where we see the most potential for a backup in, in yields and a drop in prices.

This is a good spot to take a quick break. Don't go anywhere, for the love of all that is holy. You could regret it for the rest of your days. You would miss things about international bonds, things about buying individual bonds versus bond funds. Which is better? Does it matter? What about the U.S. national debt? Is there a path to getting it under control that doesn't make things go kablooey. We'll learn all that and more coming up after this quick break. Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

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Welcome back. We've missed you. Was it a good break? You seem refreshed. Let's get right back into our conversation with Cathie Jones. She's the chief fixed income strategist at Charles Schwab. You're the bond person at Schwab. You have a stock person too. And how do you, how do you think about the relative attractiveness of bonds versus stocks? I think of bonds as like Yes, you know, I would like to get that higher return in stocks over time, but you got to do it. You need to be dutiful about buying your bonds because you need that protection when things go haywire. Sometimes you got to diversify. But there are moments when bonds become more or less attractive relative to stocks. How do you folks feel about that now?

Yeah, so my counterpart on the equity side, Liz Ann Saunders, we talk about this kind of stuff all the time. We tend to think of it as stocks and bonds, not stocks or bonds. So, it's not necessarily you're substituting one for another at any point in time. We're real believers in that rebalancing discipline. So, then when something gets highly valued, like maybe parts of the equity market are right now, you kind of trim those holdings and you reinvest. I think we're at the phase where both have potential. For upside this year. But right now, being a bond person, I look at these yields and I say, it's been 10 or 15 years since we've been able to say, hey, you can get 5% without taking much risk. Or you can look at other asset classes where you're presumably taking a bit more risk to get returns in the high single digits area. So, it's kind of a, it's not necessarily one or the other, it's kind of blending the two together and making sure you're comfortable with where you are.

Sometimes I wonder, like, what's the least I can do here? Not to sound lazy, but I always hear people talk about these kind of like investment ideas of the month. Here's a theme fund, here's a this, here's that. In the bond world, I wonder how much of it do I really need as an investor? Like, for example, if I were to buy an ETF that just has, you know, arranged maturities for let's say, treasuries and high-grade corporate bonds. Is that enough? Is there more that I need to do, or, or, or can that do the job for me for my bond allocation?

Yeah, I think that can certainly do the job. It just depends on what kind of investor you are and what kind of risk you want to take. But, you know, we have investors who only hold treasuries. They might hold a treasury ladder where they have it spread out over 5 or 10 years, but they're only comfortable with treasuries or municipal bonds, high-grade municipal bonds. That's another popular strategy for people in higher tax brackets. Makes a lot of sense to get that tax-advantaged income. For people who want a more diversified portfolio, yeah, they can have an ETF with some Treasury exposure, one with some investment-grade corporate bonds, and maybe some municipal bonds depending on their tax bracket, etc. So, you don't have to make it complicated. You don't need anything more than enough exposure within an asset class to avoid too much concentration. So you have diversification problems. So if you're going to go into investment-grade corporate bonds, I think an ETF or fund makes sense because you're going to get exposure to the whole asset class or to a large swath of the asset class. You don't want to be concentrated in all one issuer. So diversification within your allocation is as important as diversification overall in a portfolio.

You need a lot of money to diversify a bond portfolio of individual issues properly. I've heard people say, well, I want to own individual bonds because I have a maturity date and I know what I'm getting and I know when it comes due, I'll get this money back and so on. I don't want to have a fund because it's not defined when I get the money back in the fund. Is that a legitimate concern or is that a misplaced concern?

Again, it comes back to the individual investor, right? So, if you are the type of person who say would look at the value of your, the net asset value of your fund going down and say, oh my gosh, I'm losing money and sell when it's down, even if you have a 5-year time horizon, then you probably would be better off in individual bonds because you'd be more likely to hold them because you know what you're getting when you're getting and your principal back at par. But a fund can perform just as well as individual bonds. Sometimes better. It all depends on sticking to your discipline and your holding period. So, we've done the math to look at performance of, say, a diversified fund versus individual bonds, kind of similar kind of assets in it. And, you know, a bond fund is just a collection of bonds, right? So, we've looked at the performance of the two, and if you start out and say, I'm going to hold this for 5 years, and they're very similar portfolios, chances are you're going to end up with kind of the same outcome at the end, but behaviorally it's harder to hold on.

You have to live with yourself with whatever you choose.

So choose the one you could live with. Exactly. So for some people, it's just too uncomfortable to watch that fluctuation in price, not know exactly if they need their money on a given day what it's going to be worth, and then maybe individual bonds make more sense for them.

How about the case for, as a US investor, owning some bonds overseas, developed markets, emerging markets? What do you gain now? Like, how important is that now, both in terms of enhancing your returns and for diversification? Is it very important?

I wouldn't put it high on the list of importance for a US-based investor.

I'm glad you said that. Going back to me being lazy, I'm glad you said that.

Go ahead. Well, you know, it used to be you got more diversification in the developed market bonds than you do these days. Now, partly that's because in the old days, I remember when we had, you know, 17 different currencies and now we have the euro as one currency. So, it kind of consolidated the currency end of that. And the second problem we've had is, you know, we've had a strong dollar for a decade, basically. So, we've got lower yields, generally speaking, in developed markets. And currencies that haven't moved up. And cycles have moved together in developed markets pretty much over the last decade or so. So, when rates were low in the US, they were low everywhere, etc. So, our yields are higher than most developed market yields. If you look at Europe or Japan, most of those yields are lower. So, you get a negative sort of what we call cost of carry, right? You're giving up some yield to take currency risk that may or may not benefit you, and it hasn't really benefited. So I'm not saying it's a bad idea, but it doesn't— hasn't provided the diversification benefits that it might have in the past when cycles weren't so synchronized. Now, you go to emerging markets, it's a little different story. You get more yield in the local currency market, but you're going to get more volatility, more uncertainty about what your returns are going to be over time. It's a rockier ride. We think there's some opportunities there, but you really have to be the kind of investor who's willing to take those risks, and that's not for everybody.

What do you think when you look at the level of the federal debt in the US? Do you think— I used to panic about it 20 years ago. Now, I feel like I'm not as panicked, although the numbers say I should be much more panicked. So I don't even know, like, is there a path to a happy outcome or a benign outcome here? You must think about this as a bond strategist about what becomes of that over the next 20 years. What do you think happens?

What's the path there? Well, the path should be that our debt grows more slowly than our economy, and then that debt-to-GDP would level off and start to come down. It's sustainable in the sense that the average yield right now we're looking at on the Treasury market is still 2.7%. So, we have a huge economy, generates trillions and trillions of dollars. We have trillions of dollars in assets. There's no question that we can't pay our bills, right? But the trajectory is not very good because that debt is growing faster than the economy. And at some point, either you run into what they call crowding out, where we can't do the things we want to do because we're spending more money on the debt. And if we were to issue even more, would investors say, "Hey, you've run up so much debt, we need a higher yield than that," and it compounds itself. We haven't reached that point. There's nobody who can tell you with any precision what that point, that magic number is, or if we'll ever get there in our lifetimes. But when we talk about sustainability, we worry about just the fast growth rate in debt relative to the economy. Now, having said that, we've had really good news on productivity. So, if you're a country that's issuing debt or any entity really, and that debt produces faster real growth, then there's something to be said for that being used well. So, if that allows us to grow at a faster rate because we have higher productivity, not necessarily bad investment. But you still would like to see it level off a bit from here and see— allow the economy to grow at a faster rate than the debt. That would be the benign outcome. Certainly doable, but it's up to Congress to make those decisions. So, I'm not going to say that I'm holding out high hopes for that to happen real soon.

Last question I have for you, and if I have neglected to ask you something that is important right now for people to know on the subject of bond investing, please add it in. But back to the subject of, is this a good deal right now? What should I make of TIPS? When you look at the comparison between TIPS and nominal Treasuries, what role should these play in an investor's portfolio? How good of a deal do you think that they are right now?

So, you know, when you look at TIPS, you look at the implied break-even rate. That is, what does inflation need to be to make you indifferent to owning a Treasury inflation-protected security versus a nominal Treasury? And right now, those numbers are around 2% to 2.25%. So they're priced now for benign inflation outcome. If you think that that estimate is too low, you know, perhaps inflation will pick up from here and average over the long run higher than that, then maybe substituting TIPS for nominal Treasury would make sense. We never suggest going all in on TIPS because it's kind of a quirky market and you have to really watch, you know, what the issue is, issues are that you're buying, or if you're buying a fund or an ETF, there can be some underlying issues there that are a little tricky in terms of how it turns out in the long run. But You just look at that breakeven rate and you say, well, it's really priced for good news. Maybe if I go into TIPS and inflation does exceed expectations, then I'll get a little bit more than in the Treasury market. But keep in mind, Treasury Inflation-Protected Securities are still bonds, so they're going to fluctuate with interest rates. And that's something a lot of investors kind of miss, I think, when they look at that asset class.

Got it. Kathy, thanks so much for taking the time to speak with us. Most informative.

My pleasure.

I want to thank Kathy Jones at Schwab and thank all of you for listening. If you have a question for the podcast, just tape it on your phone. You can use the voice memo app. You can send it to jack.how@barons.com. You know, Jackson, I got loads of email about our financial nudism episode recently, the minimalist approach to investing. Apparently a lot of financial nudists out there. Who knew? An instant classic. And Jackson Cantrell is our producer. Jackson, if you're wondering, is away this week in Utah skiing. And he was telling me that he's teaching his wife to ski. And I'm concerned because his wife is a doctor. Your wife is a surgeon, is that right? Oh, yeah. And she— you're teaching the little kids. They're like, you know, they're close to the ground. You're not so worried about them. But teaching an adult to ski is always a little bit sort of iffy. Teaching an adult who's really important to society, like a surgeon, is Is this a risk that you really want to take? Are you doing the right thing here? Are you being responsible? Yeah, today might be the spa day. Spa day. Stick to the bunny slopes, please. I beg of you. Subscribe to the podcast on Apple Podcasts, Spotify, wherever you listen to podcasts. And if you listen on Apple, you can write us a review. That's it for us. We'll see you next week. Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.