Burton Malkiel: Bond buyers should be mindful of history

Prof. Malkiel has been for three months CIO of Wealthfront. His recommendations are now being integrated into much-expanded asset classes, managed by the Wealthfront software for 0.25% management fee. Of special interest to the retired cohort is what to do about the negative returns offered by bonds? In this FT essay Malkiel first outlines the history of what happened to bond holders the last time Treasury yields were 1.5% in 1946:


But does this flight to so-called havens really provide investors with the protection they desire? Or, are bond buyers making a huge mistake that is likely to guarantee them a period of negative real (after inflation) returns? The answer is almost certainly the latter. Bonds today in countries such as Japan, Germany, and the US are more expensive than at any time in history. Bond investors face virtually sure losses and equities are as attractive as they have been in a generation.

We can illustrate the fundamental unattractiveness of bonds with the US market. The buyer of a 10-year US Treasury bond at a 1.5 per cent yield to maturity will receive a nominal return well below the current rate of inflation and below the Federal Reserve’s informal target rate of inflation of 2 per cent. Thus, even if inflation does not accelerate, long-term US Treasuries will provide a negative real rate of return. If inflation does accelerate, that real rate of return will be further reduced.

It is important to remember what happened to bond investors the last time that Treasury bond yields were at 1.5 per cent, in 1946. Bond yields remained pegged at low rates until the early 1950s to enable the government to more easily finance the debts from the second world war. Therefore, bond prices remained fairly stable. But moderate inflation reduced the real value of both coupon payments and the face value of the bonds, and bondholders lost considerable purchasing power. And that was only the beginning of the pain.

Interest rates began to rise to more normal levels and bond prices started to fall. Oil and food shocks then boosted inflation further and, by the end of the 1970s, bond yields had increased to double digit levels. Thus, bond owners not only earned negative real income returns but also suffered punishing capital losses. No wonder a “bond” came to be considered an unmentionable four letter word and bond investors came to believe they had in effect been slaughtered. Investors should be mindful of history. The current era of financial repression may well lead once again to the euthanasia of the bondholding class.

All the developed countries of the world are burdened with excessive amounts of debt. As in the US, governments around the world are having an extraordinarily difficult time reining in entitlement programmes in the face of ageing populations. The easier path for the US government is to keep interest rates artificially low as the real burden of the debt is reduced and the debt is restructured on the backs of the bondholders. We reduced the debt to gross domestic product ratio in the US from 122 per cent in 1946 to 33 per cent in 1980. But it was achieved at the expense of bondholders.

Equities are reasonably priced and are downright cheap in comparison with bond alternatives. (…) 

Emerging market equities are even cheaper. (…) 

If you are a retired saver you should have a profound grasp of the meaning of financial repression by now. Please read the full Malkiel analysis at FT.

Wealthfront has added five new income-producing asset classes to improve bond diversification as follows:

  • Municipal Bonds
  • Corporate Bonds
  • Treasury Inflation Protected Securities (TIPS)
  • Emerging Market Bonds
  • Dividend Growth Stocks

Each asset class has a different set of risk, return and tax characteristics, so adding them gives us more ability to customize portfolios. Not every account will include all of the 11 asset classes we now use; a different subset of the asset classes will be used depending on account type and each client’s tolerance for risk. To read more about the rationale behind our changes please see our blog post, Burt Malkiel On Wealthfront’s Promise.

On the dangers of fighting the last investment war

Don’t miss this post by Viskanta Tadas at Abnormal Returns, which begins:

It is often said that generals are always preparing to the fight the last war. The same thing could be said of investors as well. Investors are prone to extrapolate the recent past well into the future. For example, nearly four years into a bull market only now are investors beginning to put money back into equity mutual funds.

This point is well-illustrated in a series of graphics from David Rosenberg, via Business Insider, showing magazine covers from the most important eras finance of the past two decades. These include the Internet bubble, housing boom and the Great Recession. These compilations show how investors become slowly convinced as to the inevitability of the trend at hand.

In terms of trends there are few more well-established than the bond bull market. For over thirty years now bond yields have done little more than go down. Maybe because the trend has been so long-standing there is no cluster of magazine covers to highlight it. However a look at the graph below shows just how far yield have come from the end of the highly inflationary decade of the 1970s.

a81f468a7cd728059b4b24cd88d40b07 On the dangers of fighting the last investment war

30-Year Treasury Bond Yield data by YCharts


Read Abnormal Returns for the complete picture – many excellent resource links. Lots to think about. Especially low-risk investors: what are their options given the state of the bond markets?

Wealthfront = Burton Malkiel, CIO + Andy Rachleff, CEO: a Silicon Valley approach to efficient asset management

Today I came across an interview with Burton Malkiel, author of the seminal  A Random Walk Down Wall Street [sorry, no Kindle edition]. I recommend the short Olly Ludwig interview at Index Universe Malkiel: Cheap Money Advice For The Wired

Why is this exciting? Based upon just an afternoon of exploration of Wealthfront.com, this one-year-old startup looks to be offering just the sort of very-low-cost investment management that everyone needs. Qualification: everyone at this stage means US-centric investors as their asset array is all US-dollar denominated. I’ll speculate that John Bogle would approve of the Wealthfront strategy: no fees for accounts <= $25,000 and only 0.25% above $25k. I’m confident that John approves of Wealthfront’s current ETF choices, which based on my testing, are heavily Vanguard-managed.

I have made a quick pass through the Wealthfront interactive client-profiling exercise, including risk-tolerance, 5-year-liquidity requirements, and investment objectives. Very well thought out. It is clear they have thought hard about how to get at the most critical client parameters while keeping the whole process accessible by the majority.

It is not yet clear to me how Wealthfront plans to manage the risk/reward of the fixed income part of the asset allocation. 

I’ve seen enough to know that we will investigate Wealthfront with some vigor. Check them out – let me know what you think, including what you find lacking. Keep in mind that you may find they offer a good fit for a portion of your financial assets, not necessarily the “whole enchilada”. E.g., your projected expenses are in a currency other than USD. Of course YMMV, “your mileage may vary”.

Phil Izzo: a look inside the Fed’s balance sheet

The WSJ has published a nice interactive graphic you can use to study the changes in the Fed’s balance sheet. See the Izzo article for a brief “look inside“.

The graphic, created by Real Time Economics, is accessed here (requires Flash).

Note that the MBS and agency debt automatically redeem, so the related portion of the balance sheet self-liquidates. So unless the Fed buys some other security, the money supply tightens automatically.

MBS have a duration of around six years. I think the agency debt is similar. The longer term Treasury’s also self-liquidate, but in Operation Twist the Fed was buying longer term bonds. Hence longer duration – I’m not sure what the duration is for this part of the portfolio.

Most of the other emergency liquidity program assets like the Asset-Backed Securities Loan Facility also self-liquidate depending on conditions. 

Meanwhile, other assets tied to emergency programs are disappearing. The Term Asset-Backed Securities Loan Facility, or TALF, ended in March 2010, and continues to fall due primarily to voluntary prepayments as the market improves and other financing options become more attractive. Direct-bank lending has fallen to the tens of millions of dollars. The Fed has sold off most of the assets related to the rescue of Bear Stearns and AIG and now just holds less than $5 billion.

In an effort to track the Fed’s actions, Real Time Economics created an interactive graphic marking the expansion of the central bank’s balance sheet. The chart is updated as often as possible with the latest data released by the Fed.

Bernanke and the Fed’s superpower

Before we get into superpowers, first read Scott Sumner: The Zen Master: Money is too tight.

OK, got that? The Zen Master is telling the Fed to use it’s most powerful monetary tool, the “expectations channel”. Ezra Klein at the Washington Post Wonkblog does a very nice job of explaining how these concepts are applied using the Spiderman metaphor.

(…)The best way to think about the Federal Reserve is that it basically has a superpower. It can create as much money as it wants. Real, American money.

And the Fed doesn’t need anybody’s permission. It’s not like when the president says he wants to do something, like the American Jobs Act, and you have to ask, “What does Congress think?” Or when John Boehner wants to pass something, and you have to ask, “Well, what does Harry Reid think?” Once the Board of Governors decides to move forward, they don’t need 60 votes in the Senate — they just do it. And that makes them incredibly powerful.

But, as Spider Man would say, with great power comes great responsibility. And so the Fed is very cautious in using its powers.

By law, it needs to try to keep unemployment and inflation low. Over the past two years or so, inflation has stayed low, and unemployment has been very, very high. But the Fed has not been doing all that much about it. It’s been hoping the situation would turn around of its own accord, or that Congress and the president would stop bickering and unleash more stimulus — anything so that the Fed didn’t have to further unleash its powers.

But it didn’t happen. And so, on Thursday, Fed Chairman Ben Bernanke said the Fed had finally decided to do something about unemployment. Something big. Something that might actually work.


If the Fed staff is quietly doing NGDPLT to a 4.5 or 5% target level in the back office, while guiding the FMOC to adjust policy to get back on track, then I believe this is likely to finally get the US economy going. Ezra Klein explains how it actually works.

I think Bernanke’s cautious wording is telling the markets that 2% is no longer the inflation ceiling but the medium term target. The markets seem to be getting that message.



Sober Look: Equity prices vs. inflation expectations

Many people are asking what impact the Fed’s more aggressive easing will have on various asset prices. One bit of informed analysis on equity prices based on the last three years data comes from the reliable Sober Look:

In recent years we’ve seen a clear indication that inflation expectations and US equity prices are correlated. Certainly once inflation reaches a certain level (by some estimates 4%), the relationship will break down and even reverse. However in the current environment deflationary risks drive this relationship. In other words we have an aggregate demand problem rather than any supply constraints. Expectations of price increases are a sign of a potentially stronger demand growth and higher margins, which is a positive for shares. The scatter plot below shows the relationship between the US equity prices and TIPS-implied (2×2 breakeven) inflation expectations over the past 3 years. The correlation has been surprisingly stable (around 0.86).

“Never Follow Your Dreams”: Mark Cuban Answers Your Questions

There’s lots of Mark Cuban wisdom in this Freakonomics Q&A. Two examples:

Q. The annual increase in the cost of college tuition seems to be much greater than inflation every year. Even during the recent financial crisis, tuitions were generally going up across the board! Seems like this is a problem waiting to happen. Do you think that we’re going to get a point soon where it won’t be a good investment to go to a private university unless you know that you’re going into a lucrative field (finance, computer science, medicine, economics)? Asked another way: my friend is going to a $40k/year private university to study finance. Is this likely to be a bad investment? –Stocker

A. We are already there. The return on education investment at a school is becoming less about the quality of education and more about the quality of networking available from that university’s alumni base.

If it were up to me, I would look very closely at limiting the size and total amount of student loans that can be federally guaranteed to $5k per year in 2012 dollars. If we limit the amount of money available in loans to students, we would create several improvements in this country:

  1. Universities would become more efficient. They would have to separate education from all the other things that universities pride themselves on.
  2. We would improve the economy and help protect the future of our kids. I think most people who look at these things fail to realize that graduating from college no longer means the entry of a “mature consumer” into the market who will rent an apartment, buy a car, buy clothes for work, etc. Instead, we get indentured servants whose only goal is to try to figure out how to not spend money so they can pay back their student loans!


Q. It seems that there is a mismatch between the skills that employers are looking for today and the skills that are being developed by college and high school graduates in the U.S. This seems like a huge problem to me. Do you see this mismatch yourself? What should (or could) be done about this? -Mickey

A. You will see new types of “trade schools” pop up to meet this demand. Six-, eight-, ten-week courses that are taught not by traditional schools, but by the new generation of trade schools that focus on programming skills, welding skills, whatever skills employers are looking for. But rather than these being accredited by educational institutions, they will be branded with the names of well-known individuals and brands.

So you could see the “Mark Cuban School of Programming” or “The Mark Cuban School of Selling.” They will be designed to give you the specific skills employers are asking for in the shortest period possible.

Read the whole thing »

In Praise of Private Equity

Alex Tabarrok writes

Excellent piece by Reihan Salam on private equity. And how Bain Capital fit into the larger picture of a dynamic economy.

The difficult truth that virtually no politician is prepared to acknowledge is that the road to job creation runs through job destruction.


What Mitt Romney discovered was that American corporations sometimes had to be dragged, wailing and whining, into a state of efficiency. As a management consultant at Bain & Company, Romney had studied successful firms and then told other firms how to replicate their strategies. But those firms had come of age in the fat years of American corporate dominance, when many believed that the Japanese could do little more than manufacture cheap toys and textiles, and many were reluctant to accept his newfangled advice. It eventually became clear that if Romney and his cohort were going to remake American business, they’d have to raise money to make their own investments. Spurred by the senior partners at Bain & Company, Romney and his merry band of consultants established Bain Capital.

I wish Romney were as eloquent in his defense as is Salam.

Sounds good, though I can’t vouch for the accuracy of the Salam analysis. I don’t have a dog in this hunt.

Demographics and stock prices

“Who will you sell your stocks to when you retire?” is an important question. With limited data, thinking through the various stories to see if they make sense is the only way to make much progress.

That’s the closing of John Cochrane’s comments on the recent San Francisco Fed paper:

Zheng Liu and Mark Spiegel at the San Francisco Fed wrote a very nice letter on demographics and asset prices, summarizing a lot of good academic work on the question.

See the graph to the left, taken from the letter: M/O is the ratio of middle aged to old, and P/E is the stock market price-earnings ratio.

It seems like a natural story: In the 1970s, there were relatively few prime-age savers around to buy stocks, and the prices fell. Starting in the 1980s to late 1990s, boomers entered their prime saving years, bought stocks and drove the prices up. And now that the boomers are retiring, they start selling, and watch out for prices! Zheng and Mark make a pretty discouraging forecast.

Read the whole thing »

Finance Defends Bain, Misses Point

A thoughtful Interloper piece on the current Bain Capital media bonfire. An excerpt:

(…) The Other End of the Pendulum

It is possible to view the socioeconomic conditions of 2005 as the converse of 1975. Thirty years ago, corporate management was largely powerless in the face of labor power, taxes were extreme and government intervention was the “vampire squid” of the age. Profits sucked and unless investors were fully exposed to the major geopolitical clusterfuck of Iran-related East tensions, returns were scarce to non-existent. Beginning with Reagan, the pendulum began to swing back, slowly crushing labor and, for our purposes, culminating with the repeal of Glass-Steagall.

To be employed in finance in the 75-05 period was to believe fully in the primacy of bottom line, profit-related orthodoxy. If nothing else, it sustained the efforts to clear the political and regulatory anti-business, socialist clutter of 1970s. As an organizing principle, faith in the bottom line provided the advantages of clarity and measurability in addition to the obvious outsized creation of wealth. Bain Capital, among many others, is the walking, talking, strutting embodiment of this thirty-year transition – the realization of a Platonic form dreamed up by William F. Buckley and other 1970s-era pro-business conservatives.

The Financial Crisis was a clear representation of the other end of the socioeconomic pendulum, and the excesses, arrogance, avarice and overall public destructiveness of finance was clearly analogous to that of organized labor and misguided government in the 70s. To blindly defend Bain now is to associate ourselves with the spluttering, enraged defenders of organized labor in the early 80s. In both cases, an intellectually-consistent orthodoxy not acclimated to criticism had ceased to function for wide segments of the population, in the current case the un- or under-employed.