Are bonds in a bubble?

NEWFOUND RESEARCH

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Asset BubblesWhat are they?

Asset Bubble: When an asset trades at a price that significantly deviates from its intrinsic value.

Asset bubbles are often difficult to observe in real-time (after all, if they weren’t it would be easy to avoid them) and are instead observed in retrospect after prices crash.

Examples: - 1600s: Tulipmania (single tulip sells for $60,000 in today’s dollars!)

- 1700s: South Sea bubble, Mississippi Bubble

- 1900s: Great Depression (NYC real estate prices down 67% in one quarter), Japan

- 2000s: Dot-com bubble (NASDAQ up 671% from Dec. 1994 to Mar. 2000, subsequently lost 78%, didn’t recover until April 2015), Real estate / global financial crisis

3FOR ADVISOR USE ONLY. NOT FOR PUBLIC DISTRIBUTION.

Asset BubblesWhat are their impact?

At their core, asset bubbles lead to depressed future returns. Oftentimes, this is because the bubble pops.


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$1.2 Growth of $1 after all-time high Emerging MarketsReturn: -3.4% Volatility: 37.9%

TechnologyReturn: -1.2% Volatility: 27.9%

FinancialsReturn: -3.2% Volatility: 42.0%

Mortgage REITsReturn: -6.3% Volatility: 31.3%

Private EquityReturn: -5.1% Volatility: 36.4%

Emerging Markets represented by EEM and data is from October 2007 to April 2016. Financials represented by XLF and data is from June 2007 to April 2016. PrivateEquity represented by PSP and data is from June 2007 to April 2016. Mortgage REITs represented by REM and data is from June 2007 to April 2016. Technologyrepresented by XLK and data is from March 2000 to April 2016. Returns i nclude the reinvestment of dividends. Source: Yahoo! Finance. Calculations by NewfoundResearch. Past performance does not guarantee future results.

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Takeaway:

Bubbles compress future asset returns.

“What the wise do in the beginning, fools do in the end”


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10-Year Constant Maturity Treasury Rate

Are Bonds in a Bubble?Historical Bond Yields (Prices)


March 2016: 1.89%Full Period Average:

5.97%All-Time Low: 1.53%

Rates certainly remain near all-time lows and well below long-term averages.

Source: Federal Reserve Economic Data from the St. Louis Federal Reserve.

Nominal (including inflation) GDP growth is a good rough proxy for interest rate “fair value.”

Why?

- If the economy returns a rate higher than prevailing interest rates, then it makes sense for businesses to borrow and expand. This is a positive return proposition since returns are higher than borrowing costs. More demand for credit should eventually increase interest rates.

- If the economy returns a rate lower than prevailing interest rates, then borrowing to invest is a losing proposition. Credit demand will fall and the cost of borrowing (interest rates) will decline.

Are Bonds in a Bubble?Model for Bond Fair Value


Bonds look to be moderately overvalued relative to nominal GDP growth.

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Economic Growth vs. Interest Rates

YOY Nominal GDP Growth 10-Year Constant Maturity Treasury Rate

Are Bonds in a Bubble?Model for Bond Fair Value


Dec. 2015 10-Year Rate: 2.2%GDP Growth: 3.1%

Source: Federal Reserve Economic Data from the St. Louis Federal Reserve. Calculations by Newfound Research.


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Increase in 10-Year Interest Rates Over the Next Year

Are Bonds in a Bubble?Probably Not in The Traditional Sense

Increase to “Fair Value” in next year would lead to -7.7%.Rates would need to increase to above 6.5% for 30% loss.

Data Source: Federal Reserve Economic Data from the St. Louis Federal Reserve. Calculations by Newfo und Research. Assumes hypothetical 10-year Treasury bondthat pays interest annually and that the rate increase occurs in year one of the bond’s life. Numbers include the benefit from the interest payment in year one.

Interest Rates vs. Forward Bond ReturnsBut Perhaps a Bubble can be Painful Without Popping


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10-Year Constant Maturity U.S. Treasury Index (1953 to 2016)

Starting 10-Year Yield Subsequent 10-Year Return

Correlation = 0.93

Data Source: Federal Reserve Economic Data from the St. Louis Federal Reserve. Calculations by Newfound Research. Assumes hypothetical constant maturity 10-year Treasury bond i ndex that is rolled over every month. Retur ns include the reinvestment of interest. Index returns are hypothetical and do not reflect fees ortransaction costs. Past performance does not guarantee future results.

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Takeaway:

Bonds don’t need to “pop” to disappoint.

“You don’t need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”


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U.S. Equities (1953 to 2015)

U.S. Equities Earnings Yield Subsequent 10-Year Return

What About Equities?Earnings Yield vs. Future Equity Returns


Correlation = 0.72

Data Source: Shiller data library (http://www.econ.yale.ed u/~shiller/data.htm). Calculations by Newfound Research. Earnings yield calculated as equity market earningsdividend by price. Index returns are hypothetical and do not reflect fees or transaction costs. Past performance does not guarantee future results.

Nowhere to Hide?U.S. Stocks and Bonds Both Historically Overvalued


Stocks overvaluedBonds overvalued

Stocks undervaluedBonds overvalued

Stocks overvaluedBonds undervalued

Stocks undervaluedBonds undervalued

1999 to 20090.6% per year after inflation

1981 to 199110.5% per year after inflation

2015

Data Source: Shiller data library (http://www.econ.yale.ed u/~shiller/data.htm) and Federal Reserve of St. Louis. Calculations by Newfound Research. Data for the periodfrom 1953 to 2015. Cyclically Adjusted P/E Ratio is a version of the P/E ratio that averages earnings over the prior ten years. The 50/ 50 portfolio is a hypothetical indexthat is rebalanced annually. Index returns are hypothetical and do not reflect fees or transaction costs. Past performance does not guarantee future results.

Colors represent forward 10-year return on a 50/50 stock/bond portfolio. Darker orange indicates lower returns and darker green indicates higher returns.

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Nowhere to Hide?U.S. Stocks and Bonds Both Historically Overvalued


Expected Returns from Research Affiliates

U.S. Large Cap Stocks U.S. Core Bonds 60/40 U.S.

Stock/Bond Portfolio

Yield 2.2% 0.8% 1.6%

Growth 1.3% 0.8%

Roll Return 0.7% 0.3%

Credit Loss -0.3% -0.1%

Valuation -2.2% -0.4% -1.5%

FX 0.0%

10 Yr. Expected Real Return 1.3% 0.8% 1.1%Source: Research Affiliates. Data as of 3/31/16. Expected returns are calculated by Research Affiliates using data from MSCI, Bloomberg, and Barclays. Theseforecasts are forward looking statements based upon the reasonable beliefs of Research Affiliates and are not a guarantee of future performance. This content is notinvestment or tax advice.

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Takeaway:

Value matters.

“Price is what you pay; value is what you get.”


Nowhere to Hide?Expand Your Horizons, Especially With High Income


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10-Year Expected Real Returns from Research Affiliates

Source: Research Affiliates. Data as of 3/31/16. Expected returns are calculated by Research Affiliates using data from MSCI, Bloomberg, and Barclays. Theseforecasts are forward looking statements based upon the reasonable beliefs of Research Affiliates and are not a guarantee of future performance. This content is notinvestment or tax advice.

Nowhere to Hide?Expand Your Horizons, Especially With High Income


Expected Returns from Research Affiliates

60/40 U.S. Stock/Bond Portfolio Diversified

Yield 1.6% 2.3%

Growth 0.8% 0.2%

Roll Return 0.3% 0.6%

Credit Loss -0.1% -0.5%

Valuation -1.5% -0.5%

FX 0.0% 0.5%

10 Yr. Expected Real Return 1.1% 2.7%Source: Research Affiliates. Data as of 3/31/16. Expected returns are calculated by Research Affiliates using data from MSCI, Bloomberg, and Barclays. Theseforecasts are forward looking statements based upon the reasonable beliefs of Research Affiliates and are not a guarantee of future performance. This content is notinvestment or tax advice. The diversified portfolio consists of a 12.5% allocation to U.S. large-cap equities, a 7.5% allocation to EAFE equities, a 5% allocation to EMequities, a 5% allocation to long-term Treasuries, a 10% allocation to U.S. core fixed income, a 10% allocation to global core fixedincome, a 5% allocation to REITs, a 5% allocation to U.S. TIPS, a 10% allocation to high yield, a 10% allocation toUSD EM bonds, a 10% allocation to local currency EM bonds, and a 10% allocation to bank loans.

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Takeaway:

Opportunity exists globally and in high income asset classes.

“You can get in a whole lot more trouble in investing with a sound premise than with a false premise.”


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Disclosures


Performance during the backtested period is not based on live results produced by an investor’s actual investing and trading, but was achieved by the retroactive application of a model designed with the benefit of hindsight, and is not based on live results produced by an investor’s investment and trading, and fees, expenses, transaction costs, commissions, penalties or taxes have not been netted from the gross performance results except as is otherwise described in this presentation. The performance results include reinvestment of dividends, capital gains and other earnings. As the information was backtested, it does not reflect contemporaneous advice or record keeping by an investment adviser. Actual, live client results may have materially differed from the presented performance results.

The Hypothetical Information and model performance assume full investment, whereas actual accounts and funds managed by an adviser would most likely have a positive cash position. Had the Hypothetical Information or model performance included the cash position, the information would have been different and generally may have been lower. While Newfound believes the outside data sources cited to be credible, it has not independently verified the accuracy of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.

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Are bonds in a bubble?

Economy & Finance

Transcript of Are bonds in a bubble?