Bonds and Borrowed Time

Bond market investors had a tough first half. When interest rates rise, bond prices fall. This is confusing for a lot of folks, so imagine you own a ten-year treasury note with an 8% coupon. If interest rates on new bonds being issued today were around 5%, your bond paying the higher rate of 8% would be worth more than par to a prospective buyer. Conversely, if rates were to rise to 10%, you would not be able to sell your 8% bond for par because a prospective buyer could now get 10% elsewhere. This is what is known as interest rate risk.

Another type of bond risk is credit risk. If you own shares of a bond fund that holds bonds issued by a struggling company or government, you may see the value of your bond fund fall even though interest rates haven’t moved very much. This is because the ability of the issuer to pay interest and make good on principal is being questioned. The greater the uncertainty, the lower the bond price will fall.

Many bond investors suffered declines as a result of both risks. Farr, Miller & Washington bond managers have enjoyed a better experience because they have been very cautious. We have kept our maturities relative short, which lessens the impact of interest rate increases. At the same time, research is ongoing on every bond purchased for our portfolios to ensure the issuer’s ability to make timely payment of interest and principal. We never see cause for speculation with fixed-income investments.

The Federal Reserve has been buying both Treasuries and agency mortgage-backed securities at a rate of $85 billion per month. The Fed has undertaken this program of “Quantitative Easing” in order to keep interest rates at very low levels, thereby stimulating investment and consumption. As a consequence of improved economic data, the Fed has now suggested that at some point in the future they may reduce the amount of their monthly purchases. This suggestion spooked investors and rates moved higher. Higher rates mean that already struggling issuers, such as some municipalities, will have to pay even higher costs for new bonds they may issue. This fortifies the economic headwinds they are facing already.

In stock land, earnings season is in mid-stream. Reports continue to show lackluster revenue growth with modestly better gains on the bottom line. It strikes us as illogical that earnings will remain robust without increasing revenues. Price-to-earnings multiples remain a bit above average and earnings margins for the S&P500 are near all-time highs. If the gains in the equity markets are to be maintained, revenue growth must resume.

We have been through these ambiguous periods before and know that they can last much longer than most ever expect. When prices seem to creep ahead of fundamentals, we conclude one of three things: our evaluation is flawed (and prices and fundamentals are not out of line); fundamentals will improve to support prices or; prices will come down to a level supported by the fundamentals.

It is really important at periods like this to make sure that your holdings have substance: strong balance sheets, highly visible revenue and income streams, market share, and high-integrity management. While all boats get battered by storms, sturdier boats fare better and are more comfortable for passengers. Farr, Miller & Washington has long advocated these higher-quality, blue-chip companies. The markets seem to agree with us, and our advocacy continues.

Peace,

Michael