Chris Davis: Investors should be worried about bond bubble
By Chuck Jaffe, MarketWatch
BOSTON (MarketWatch) -- The investment move that has made consumers most comfortable since the market crisis of 2008 is about to become the investment folly of the 2010s.
That's according to Chris Davis, head of the Davis Funds. He said recently that bonds are an emerging bubble, destined for a fall over the next decade, just as investors have been throwing virtually all of their available cash into bonds so that they could sidestep the pain in the stock market.
"The only real bubble in the world is bonds," Davis said, at the CFA Institute annual meeting. "When you look out over a 10-year period, people are going to get killed."
While Davis may not be a household name to many investors, he represents a long and storied brand in the fund business, a third-generation fund manager whose firm runs $65 billion in assets, and whose management acumen is widely hailed as being a model of sound thinking.
Thus, if you are one of the investors contributing to those record bond-fund inflows, his message should be terrifying.
Davis did not predict an immediate implosion in the bond market -- he said it might hold up well for up to two years -- but he said he believes a fall is inevitable.
"When you have deficits this high and rates this low, something has to give," he said, "and I don't think you can look at this and think the deficits are going to give any time soon."
Rising-rate environments are bad for bond funds because bond prices fall when rates go up. A bond fund must "mark to market" at the end of each day, meaning it prices its securities as if it was selling them. Thus, when bond prices fall, bond funds suffer.
That's hardly a new thought; in fact, plenty of attendees and experts at the CFA conference were thinking the same thing -- that there's way too much debt in the world and that it's time to pay the piper.
Stocks as safe haven
Davis's point, however, was a bit different. He suggested that the problem for most investors is that they are looking at bonds as a safe haven when, in current conditions, the safer place is actually stocks. He wasn't advocating a "buy, buy, buy" bull-market mentality -- he did not suggest average investors dump all bond funds or go whole-hog into stocks - but based his comments on the numbers, specifically on yields.
Davis said the current dividend yield on stocks is roughly 3%, about the same or a hair less than what an investor can get on bonds. Looking at your investment as "funding an enterprise," Davis urged looking at the "earnings yield," which goes beyond the dividend payout to include what the business itself keeps.
When examined that way, he said that investing in bonds when the government is so deep in the financial hole is much riskier than buying a stock like Nestle, "which has a 7.5% earnings yield, where it is reinvesting half of that money in the business and pays the other half to you in dividends."
Further, corporate yields tend to adjust automatically to inflation, through the price increases that big companies can pass along to customers, whereas bond yields lose ground if inflation returns to the market.
"If people got their statement and looked at the dividend yield and earnings yield, they might do things differently right now," Davis said. "But you have to be able to numb yourself to changes in stock prices, and most people can't do that."
Here's where his dire forecast for bonds comes back to roost. Most investors seek bond funds for safety, income and stability. While bonds will likely remain safe, bond funds that get hammered when the rate picture changes will not feel very stable or secure; instead, they will be acting more like stock funds. And since the income component from a bond fund is not likely to be any better than the dividend stream cast off by a fund buying high-quality stocks, there's a real case to be made that it will be stock funds, over time, that provide a lot of what investors are expecting when they buy bond funds.
Davis acknowledged that many observers are calling for the stock market to take a major and protracted downturn, so he brought up the idea of a worst-case scenario, another Great Depression, where the market basically had 25 years -- from 1929 to 1954 -- of "going nowhere."
Investors who simply made a deposit on the first of each year and rode it out, however, wound up with a 13% annualized gain over that period, thanks to dividend yields.
The problem with the flood of money to bond funds, Davis said, is that "it pushes people the way they want to go, and not the way the market might suggest they want to go. They feel better, but what they are doing is very, very dangerous."
Chuck Jaffe is a senior MarketWatch columnist. His work appears in many U.S. newspapers.