My swan song as a strategist?

From the Wall Street Journal, Nov 30 2018, under the title, Bond Indexes Bend Under Weight of Treasury Debt:

“The Treasury Department projected to run trillion-dollar deficits for the foreseeable future. As issuance increases, funds that use the Bloomberg Barclays aggregate index as a guidepost for portfolio composition will wind up owning increasingly large amounts of Treasury debt. Independent bond analyst David Ader predicts Treasurys will make up half of the U.S. bond market and the indexes that track it by 2028.”

I was quoted the other day in the WSJ as an independent strategist which, I think, quite the appropriate designation for now and perhaps forever.  I must admit I liked both the attention from the media and the calls I got from former readers of mine asking for more details.  

The point of this Musing is not to go over my current career status or lack thereof but to go over the topic for a lay audience to the extent anyone is actually reading this blog of mine.  It might be my swan song as a bond strategist and I’m quite proud of my insight into the topic.  Maybe it reveals to you a bit of the expertise I’ve offered that normally would put you to sleep.

Here it goes.  There are two types of investors, active and passive.  If you buy an ETF or index fund you are a passive investor.  The things you are buying are determined by a very specific index, like the S&P 500.  There’s no discretion or analysis involved; you buy a very defined basket of things.  This type of investment has been growing HUGELY over the last 25 years in the stock market.  Even ‘active’ managers are measured against the passive index and so follow an index in the hopes, rare, of outperforming it.

Indeed, a majority of investments in mutual funds and ETF in the stock market are today passive.  The advantage is low fees.  Vanguard’s VOO, the S&P 500 index ETF, charges 0.04% in fees vs. closer to 1% for active funds.  How do they do this?  They don’t need highly-priced portfolio managers, researchers and the like but simple computer programs to manage the money.  That’s simplistic but close enough to capture the story.

The bond market is only recently making the same move from active to passive management.  Why?  Because there are literally millions of bonds out there.  When IBM issues a share of its stock it’s all the same; a share is a share is a share.  When it issues a bond each bond is new with different characteristics like the coupon (or yield) and maturity.  That raises the issue of liquidity, i.e. you can sell a share of IBM easily and cheaply, but with so many bonds out there, price ‘discovery’ is harder and requires more intelligence and insight which makes ‘active’ management more important.

It’s rather complicated with the bond market or so we claim (or hope).

But that is changing dramatically and passive investing in bond index funds and ETFs is surging.  That’s because, 1) with low interest rates, no one wants to pay high fees (if you’re earning just 3% in interest, paying 0.4% in fees is insulting), 2) computers make it easier to come up with a fair price, and 3) electronic trading makes getting that fair price fast and cheap.

Here’s where I come in.  I consider how the structure of the bond market is changing to determine demand based on that structure.  Consider this. If you manage an S&P 500 fund and a stock, like GE, is kicked out you have no choice but to sell it and replace it with the stock that came into the index.  Make sense?

Well it works the same in the bond market. IF, there are more of a given bond in the market (you can substitute index for market) then passive investors have to buy that bond.  Simply, there’s more of that in the index.

With me so far?  So look back at the chart at the start of this musing.  There you see a snapshot of the bond market today from official data; it’s an allocation in percentage terms of the main components to the bond market.  To the right of the vertical line is my projection of that allocation in the next 10 years, also based on official forecasts (from the Congressional Budget Office in the case of the Treasuries).

What you see is that Treasuries will rise to over 50% of the bond market in 10 years from about 40% today.  This is a direct result of the massive budget deficits we have in the United States; higher deficits means more Treasury bonds need to be issued to pay for that deficit.  (I think the ‘risk’ is that it’s more like 55% but that’s another story and pure speculation on my part.)  In any event, that rise means that passive investors have to buy Treasuries to keep up with changes to their index.  

That translates to an intrinsic and forced need to buy Treasuries in the years to come.  High deficits like this will slow economic growth (if the government is borrowing, they crowd out other borrowers and will have to eventually pay for the deficits with higher taxes or less spending or both).

Which is all to tell you that this demand, from passive investors, in the bond market is one element that will keep interest rates from rising a lot for years to come.  And if I’m really out of my career that last sentence is a bloody good way to conclude it.