Value Investors; Bonds: That Silly Mr. Market by Kendall J. Anderson, CFA, Anderson Griggs Investments
I’m sure you remember my friend Mr. Market. He was introduced to me a few years after I entered the business of investment advice via Ben Graham’s book The Intelligent Investor, and for most years since I have found him to be quite fair and reasonable.
Whether I wanted to sell or buy any one of the thousands of securities available to the public, he would make an intelligent opinion of its value and proceed to close the deal at that price. However, Mr. Market’s decisions can be affected by irrationality and moodiness. At times he will be brilliant and worth our undivided attention. On other occasions he may be completely off-base in his opinions.
As with any long-standing friend, we know his strengths and his weaknesses. We know Mr. Market lives in a short-term world. He has to constantly work hard to set a respectable price minute by minute, day by day. This is his greatest strength; it also is his greatest weakness. He does not have the luxury of planning for his long-term future.
Knowing that Mr. Market has had decades to develop his short-term skills, we have come to recognize that our only advantage over Mr. Market is time, and with this knowledge, we build and maintain our portfolios. However, this approach does come with a price, which is measured in dollars over a very short-term period. At times this price can be so unbearable that our human weaknesses take over, and some of us succumb to the lure of trying to beat Mr. Market in the day by day race, hoping to maximize short-term rewards. Others give up, and swear off owning any and all stocks, bonds, and other securities available in the marketplace.
As a long term value investor our portfolio returns can, at times, pay this price in the short-term for being a bit different. Over the past few months our lack of owning bonds in our conservative accounts has held back our relative returns. In addition, our ownership of large and powerful companies whose products are sold around the world have seen price declines due to the strength of the US dollar. We will take a little time in this letter to discuss these. In addition, I want to share with you my thoughts on why it can be difficult to be a value investor and earn the excess returns a value strategy offers.
Bonds and other income bearing securities have been the preferred investments for both individuals and financial institutions for decades. There is a perfectly acceptable reason for this. When you own a bond, you are promised an interest payment for the use of your money and are promised that your principal will be repaid at some future date.
Mr. Market is adept at setting the market rate of interest. He bases these rates on the ability of the borrower to repay the principal in the future, the expectation of future inflation, and in the short-term, the amount of buyers willing to lend their money relative to the amount of borrowers in need of a loan. As the lender, or the owner of the bond, the largest reward, if not the only reward, will be the interest paid to us in a check. Because of this, we want to own bonds when we are completely satisfied with the interest rate paid until maturity.
Most of us know that Mr. Market sets prices for common stocks, and we recognize that at times he has been quite silly in his pricing. Some of us have first-hand experience with this, as fifteen years ago he was pricing technology “ideas” for millions, if not billions of dollars. What many of us do not realize is that Mr. Market can be just as silly when he prices bonds. I believe today he is truly showing us this side with the pricing of fixed income securities. Let’s see if you agree with me based on some of his recent actions around the world.
In early April the Swiss government sold a bond with a negative interest rate that will mature in 2025. Let me explain this with a little story. As you know, our office is just upstairs from the lending department of one of our local banks. Last week I went downstairs to visit with my local banker, who was all ears when I wanted a loan for one million dollars ($1,000,000). This is the deal I offered him: “If you lend me this money I promise to pay you back $950,000 in ten years. Of course there will be no interest paid on the loan and if for some reason I die in the next ten years you will receive nothing.” Do you think my banker would give me the $1,000,000 under those terms? Of course not, yet the Swiss government had no problem at all obtaining a loan from Mr. Market under very similar terms.
Mr. Market made another loan last week. This time the loan was to the government of Mexico. Being a neighbor to Mexico, I know a couple of things about the country. First, it has unfortunately had a history of not paying obligations in a timely manner. Second, some Mexican citizens have not been too happy with their government or with their lives in Mexico, and have chosen to leave their homeland for greener pastures. In contrast to the Swiss bond, there is some doubt in regards to whether interest will be paid by Mexico or whether the principal will be repaid when the loan matures. Of course Mr. Market took this into consideration when he lent Mexico funds, and he decided it was a good idea to charge some interest. He decided to charge Mexico 4.2%. Some of you may think this is not so bad. After all, we can’t get that much interest here in our town. But in order to get the 4.2%, Mr. Market had to agree that Mexico would not repay the principal for 100 years. That silly Mr. Market… doesn’t he know that everyone who borrowed these funds will be dead before the promised repayment date? Do you really think the great grand babies of the borrowers will be saving their money to repay this debt ten decades from now?
Mr. Market’s loans to Switzerland and Mexico are not the only demonstrations of his silliness. He has lent trillions of dollars to nine other countries around the world at a ten year repayment date with the sole requirement of an interest payment of less than ½ of 1% (0.50%) per year. This is the equivalent of being paid $5.00 a year for every $1,000 borrowed. Belgium, Finland, France, Germany, Netherlands, Sweden, Switzerland, Czech Republic and Japan have gladly borrowed money from Mr. Market for almost nothing.
It’s true that the bond market has produced some pretty good returns over the past thirty years, and some will say that owning bonds provides the benefits of diversification, or that Mr. Market is always correct and smarter than all of us. Although not owning intermediate or long-term bonds over the past couple of years may have minimized the total returns earned