The Bear’s Lair: Ban the bonds!

Standard investment textbooks and advisors mandate that you should have a percentage of bonds in your portfolio, the percentage rising with age (my Vanguard page advises me to have fully 70% of my money in them). Yet bonds offer no upside, they do not protect against inflation, and lawyers working for borrowers have ensured there are all kinds of downside traps. The standard advice is wrong — in an era without a Gold Standard, investors should avoid bonds altogether.

Back in 1751, when the great Portuguese-Jewish financier Sampson Gideon, in conjunction with Britain’s prime minister Henry Pelham, invented Consols by consolidating all the existing British government debt into a single huge issue, perpetually bearing 3% interest from 1757 on, there was no question that British government bonds were a good and sound investment, although bonds of other governments were dodgier. (Even the Netherlands, though blue-chip at the time, defaulted when the deadbeat France occupied it in 1795.)

There was no coupon risk on Consols, nor any long-term inflation risk, because Britain had been led in 1717 by Sir Isaac Newton as Master of the Mint onto what became the Gold Standard. There was a price risk, however. During wars, increased supply of bonds and increased risk of default sent Consols prices tumbling. There was also an occasional devaluation risk – in 1797, the year the Bank of England suspended gold payments, the average price of Consols was close to 50% of par, consumer prices came close to doubling in 1792-1800 and the gold price rose to 125-130% of parity. Nevertheless, despite Britain’s huge debt in 1815, almost 250% of GDP, double the current level, Consols remained a solid long-term investment with a positive real return after inflation, even after the minimal taxes payable, until 1914.

With the abandonment of the Gold Standard in 1914, even though there was no default, British government bonds became a very poor investment. At their nadir in 1974, Consols, by now with an interest coupon of 2½%, traded at 14% of par, in pounds that were worth around 10% of their 1914 value – in other words, a loss of 98.6% of principal. That is an extreme example of bond risk in an era of inflation – the longer the maturity of a bond, the further the price can fall in an inflationary period and the less the nominal principal will be worth.

Without a Gold Standard, governments are always tempted to finance as much as possible of their profligate spending through the central bank, and this inevitably leads to rising inflation. That in turn leads to declining bond prices and value (I will consider the case of inflation-linked bonds below). Since governments’ tendency to produce inflation is universal, and fixed interest rate bonds by definition provide no protection against that inflation, they have a permanent ratchet against their investors and should be regarded with deep suspicion at the very least.

Consider, for example, the current set of U.S. Treasuries. The 10-year bond yields 2.14% as I write, the 30-year bond yields 2.47%. Yet both yields are utterly pathetic compared to the consumer price index inflation rate of 7.9% in the year to February. Interest rates will have to rise until long-term government bonds yield more than the inflation rate, which seems unlikely to drop significantly in the next year or two. Hence, if you buy a long-term U.S. Treasury you are likely to get a substantial nominal price decline as interest rates adjust, plus real erosion of your capital at a rate much faster than you earn interest on it. No, thank you! There should be no place for any such terrible deal in anybody’s retirement portfolio; it’s not risk-free, it is a guaranteed loss.

Aha, you say, but we can invest in Treasury Inflation-Protected Securities (TIPS) and avoid the inflation risk. In current markets, these are a better deal than government bonds, but they have three problems. First, when inflation threatens, as now, they have a negative yield, currently of minus 0.81% for 10-year TIPS, so they don’t provide full inflation protection and have a substantial price risk when nominal yields rise to normal levels, as their yield can be expected to rise to plus 1-2% and their price correspondingly decline.

Second, the government fudges the inflation index. This is true in all countries; it is clearest in Britain, where the original inflation-indexed bonds, issued in Margaret Thatcher’s time, were linked to the Retail Price Index (RPI). The government discovered this was rising too fast, so got a gaggle of economists to tell the public it was unrepresentative, and invented a new index, the Consumer Price Index (CPI) to which all modern index-linked bonds are linked. Regrettably for the government, the original bonds are still outstanding, so they have to publish the RPI in very small print. Whaddyaknow? In the year to January 2022, the RPI rose 7.9%, whereas the CPI (to which everybody’s pensions are of course linked) rose only 5.5%.

The British government is still fiddling the figures; this month they announced that men’s suits, which Britain invented, will not be included in the CPI, while vegetarian sausage meat will be. Guess which of those two items goes up faster in price, and which a normal person (male I grant you) buys more of! The same fiddles are going on in the U.S. and are intensifying. I fully expect the government to announce shortly that, given the importance of the metaverse, 50% of the CPI will be virtual, linked to the price of computer processing power (which famously declines every year).

For U.S. TIPS, there is a third problem, which is that the inflation uplift from price rises is paid out in cash and is tax-deductible. This means that if inflation is 5%, say, the bond yields a net 4.2% (0.8% below inflation) but then pays tax at the income tax rate of say 35% on its 5% inflation uplift pay-out, for a net yield of 2.55% below inflation (0.8% plus 1.75% spurious tax). No, thank you!

Even if you go beyond government bonds, seeking the higher yields of corporate bonds, risks abound and returns don’t. The most important reason for this is that the bond indentures are drafted by lawyers hired by the issuers, not by investors. Back in the old days, in Britain and the United States, merchant/investment banks worked for investors as much as issuers – issuers found it difficult to shift between banks, whereas attracting investors was key to having an issue that sold out and was not left on the manager’s books.

However, since competitive bidding for issues was introduced around 1980, issuers have been able to switch bankers at will, and so tendering to their whims has become uppermost in the managers’ mind. For old-fashioned “investment grade” corporate bonds this does not matter so much, but such bonds are an increasingly small percentage of the market, only around a quarter if “investment grade” is defined as A-rated or above, as it should be. Even for these bonds, the spate of securitized issue defaults in 2008 shows how far lawyers and issuers will go to pull the wool over investors’ eyes. As interest rates rise in this cycle, we can expect a similar series of collapses both unexpected and un-signaled by the fairly inept bond rating agencies.

Below investment grade, investors’ rights are not what they think they are. Internationally, collective action clauses, a scam invented by the International Monetary Fund around the turn of the century, prevent bondholders from taking action against defaulting borrowers and give the IMF the ability to “restructure” borrowers’ debt, putting its own interests first and the interests of bondholders last. Then if interest rates decline, and bond prices rise above par, borrowers can use hidden tricks to call the bonds and refinance them at a lower rate, even if the published terms prevent them from doing so.

Finally, with the proliferation of hedge funds in the market, all kinds of scams become possible, with the small private bondholder without inside information always last in the queue. The words “leveraged buyout” should bring a chill of fear to every holder of good-quality corporate bonds, as huge loads of additional debt are piled on the borrower, without existing debtholders having much or any say as their security is destroyed.

As an investor, you are better off with banknotes stored in a sock, provided it is a nice dry non-corrosive sock. Bonds are like banknotes in a wet sock in an acid bath; take your eye off them for a moment, and they will have lost some of their value.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)