Bonds have had a rough few years (that’s putting it mildly). If you owned them, you probably regret it. If you didn’t, you’re probably not sure you want to start now.
And if you’re in private credit, there’s another burning question on your mind. Is that 9% yield worth locking up your money when public high-yield bonds offer a competitive return and you can sell them any day?
Itai Lourie spent 26 years in institutional fixed income and now writes Unstable Equilibria. In today’s guest post, he takes apart what investors have been sold about bonds: the permanent allocation, the 60/40, and the promise of downside protection.
He also looks at what bonds can actually do for investors today, including a straight comparison of high yield and private credit.
If you’ve been following my coverage of evergreen redemption queues and who’s financing the AI buildout, you’ll want to read this one.
-Leyla
The views expressed are the author’s own and do not necessarily reflect those of Accredited Investor Insights. This article presents general investment views, not investment advice. Companies and indexes named are illustrations, not recommendations. The author and/or Thresher Capital may hold positions in securities discussed. Past performance does not guarantee future results; scenarios are hypothetical and not forecasts. Investments can lose value, including all option premium paid; suitability depends on the investor’s circumstances. Hypothetical calculations exclude taxes and costs.
Bonds are all the rage these days. Not the good kind of rage, the kind where you’ve owned them and hate them or haven’t owned them and have no idea what to do with them.
How high can rates go? When should I buy? What should I buy? Are credit spreads too tight? When will the next Game of Thrones book come out?
I don’t know how high rates can go. Some credit spreads are too tight and some are too wide. That last book is never coming out.
I spent 26 years in institutional fixed income, the last stretch co-running more than $60 billion. I ran the interest-rate book, managed structured products through ’08 and helped clients manage liabilities. I don’t have the high-conviction forecast everyone seems to want. I do have some opinions about what belongs in a portfolio.
The question I would start with – What can bonds do for me?
The answer is different for everyone and is probably not what you have been sold.
Bonds 101
When I buy a fixed-rate bond, I’m buying an issuer’s promise. In exchange for my money, I get interest for some amount of time and then I get my money back.
Given the price I pay, those payments imply a return. That return is my yield. It should be better than nothing and usually better than cash.
Yield is the best predictor of return for a bond held to maturity, but it isn’t a guarantee. If the issuer doesn’t pay, if coupons get reinvested at lower rates, if you sell before maturity, your return will be something else.
More yield usually comes with a catch. More risk.
You want more “risk-free” Treasury yield? Buy longer bonds and take the risk that rates move higher.
You want more yield than Treasuries? Take credit risk. The riskier the borrower, the more it pays. That extra yield is the spread.
Or maybe give the borrower the right to pay you back early. Mortgages are the everyday example. Homeowners refinance when rates fall, so you get your money back exactly when you don’t want it. That’s convexity risk.
And here’s a dirty little secret. Investors have been underpaid for taking convexity risk for years. The MBS index struggles to generate excess return over Treasuries. Close to flat for ten years.
Nothing is free, and sometimes even nothing is overpriced.
A few other things matter: