Cullen Roche sat down with Stig Brodersen to discuss how to frame Macro Investing into your financial planning framework on the We Study Billionaires podcast.
There are some gems in the interview because Cullen understands value investing and macroeconomics but has spent his career in wealth management in a financial planning manner. I am sure because he needs to explain complex macro-concepts to his old clients in an understandable manner, he has some good analogies to describe some of this stuff.
In the interview, Cullen was asked if we enter a period of rising interest rates for decades instead of falling, does this affect how we look at bonds. I thought Cullen’s response was pretty insightful, so I decided to rephrase and list it here.
The Appeal of Owning Bonds Become More Attractive Today Despite the Uncertainty
We can buy six and twelve-month treasury bills now at a 4% yield, a world that did not exist in the last ten to fifteen years. With a six-month bill, you will get a one-time coupon. The bill will not do anything for six months, but you will recoup at principal value. You just have to wait and let the bill capture the return.
The risk you face when the market interest rate is at 4% is very different from when the rate is at 0%.
Many people think about bonds and the 1970s and think that bonds were terrible investments because the interest rate went up so much. The exciting thing about bonds is the more interest rates go up, you will generate more significant income from the new bonds you will roll your matured bonds into.
For example, buying a bond generates a nominal return of 8%, and inflation is at 8%. The interest rate has to continue to skyrocket even more because the interest rate has to outpace a very high 8% inflation.
If you own a 5-year bond, the bond’s duration, which measures the bond’s sensitivity to interest rate fluctuation, is five years. When the market interest rate goes up by 1%, you lose 5% on the value of your 5-year bond.
When that happens, you lose all of your coupons earned in the annual year due to the rise in the market interest rate because the loss in bond value is equal to the 5% coupon rate paid out to you. But if someone buys your 5-year bond (which has a 5-year duration) when your bond’s yield-to-maturity is at 10%, that new bond owner will have to lose bond value equivalent to two years of bond coupon to lose money on that bond. The new bond owner’s risk of a poorer investment outcome diminishes as the bond he bought is more attractive.
In this regard, bonds operate a lot like stocks in that when the market interest rate rises, the prices of existing bonds fall, but the future returns of the existing bonds become better.
The stock market tends to function similarly. When the stock market falls in value, your existing stock investment (as a basket) tends to become a higher return-generating instrument in the future.
Where we are right now, if interest rates continue to soar, you will continue to incur principal losses on your existing bonds. But the math is now vastly improved for you because you can buy bonds yielding 5%, or 6%, so your starting point is much better protected in this world than when the market interest rate is at 0%.
Many argue that bonds are dead and useless in a model portfolio. There are valid arguments about its poor value proposition two or three years ago, but today the math is completely transforming.
Bonds are far superior today because market interest rates have risen, and the likelihood that interest rates will continue to rise at the current pace, in Cullen’s opinion, is lower. This makes bonds even more attractive going forward.
Your Bond Allocation Should be Highly Personalized
Everybody shouldn’t own bonds, and not everybody needs these short-term instruments that provide certainty over a specific time horizon.
Whether you should own bonds should be very personalized and customized. We should all look to build personal and systematic fixed-income portfolios based on our time horizons.
The dynamics of owning 30-year, 5-month or 5-year bonds/bills are entirely different. You will need to own bonds based on the specific time horizon within your financial plan, where you know the mathematical outcomes that will likely happen from a nominal perspective.
If you own a 30-year treasury bond, you are taking on a crazy amount of 30-year bond duration risk, when you may need the money much sooner. (For more on this, you can refer to my article on How does a Bond Index Fund Recover its Value After being Decimated by Rising Rates?)
Cullen thinks people should not look at bonds as real return protection. That is why he is not a real fan of owing TIPS or inflation-protecting securities in the fixed-income markets.
Bonds should be mainly principal protection instruments that provide principal stability over a very specific period.
For example, the treasury bill you bought today at 4% has no chance of beating the inflation rate, but that is not the goal of the instrument. The goal of that bond instrument is to give you a 4% nominal certainty instead of getting 0% if you let the money sit in the bank. The bond is a no-brainer to own IF you have a six-month time horizon.
Build a Bond Ladder as Your Bond Allocation
Cullen’s perspective about bonds in a portfolio is not the popular return per unit risk optimization explained in the Modern portfolio approach. He approaches it from the perspective of having money for a specific time horizon when needed so that you can have a greater certainty to meet certain liabilities in life.
This comes from a liability-driven investing (LDI) or asset-liability matching approach.
He likes building bond ladders in a systematic fixed-income portfolio.
For example, you can divide $100,000 into ten portions. Take $10,000 and bucket out with ten bonds that mature from one to ten years. Every year, one of the bonds in your portfolio will mature, and you can systematically roll them over to a new set of bonds.
You do not have to care about the market interest rates.
Here is a visual illustration of a 12-year bond ladder from Pimco:
The beauty of a bond ladder is that you are certain that the principle on your short-term bucket of money is there to meet your cash flow needs.
If you want to trade these stocks I mentioned, you can open an account with Interactive Brokers. Interactive Brokers is the leading low-cost and efficient broker I use and trust to invest & trade my holdings in Singapore, the United States, London Stock Exchange and Hong Kong Stock Exchange. They allow you to trade stocks, ETFs, options, futures, forex, bonds and funds worldwide from a single integrated account.
You can read more about my thoughts about Interactive Brokers in this Interactive Brokers Deep Dive Series, starting with how to create & fund your Interactive Brokers account easily.
I invested in a diversified portfolio of exchange-traded funds (ETF) and stocks listed in the US, Hong Kong and London.
My preferred broker to trade and custodize my investments is Interactive Brokers. Interactive Brokers allow you to trade in the US, UK, Europe, Singapore, Hong Kong and many other markets. Options as well. There are no minimum monthly charges, very low forex fees for currency exchange, very low commissions for various markets.
To find out more visit Interactive Brokers today.
Join the Investment Moats Telegram channel here. I will share the materials, research, investment data, deals that I come across that enable me to run Investment Moats.
Do Like Me on Facebook. I share some tidbits that are not on the blog post there often. You can also choose to subscribe to my content via the email below.
I break down my resources according to these topics:
- Building Your Wealth Foundation – If you know and apply these simple financial concepts, your long term wealth should be pretty well managed. Find out what they are
- Active Investing – For active stock investors. My deeper thoughts from my stock investing experience
- Learning about REITs – My Free “Course” on REIT Investing for Beginners and Seasoned Investors
- Dividend Stock Tracker – Track all the common 4-10% yielding dividend stocks in SG
- Free Stock Portfolio Tracking Google Sheets that many love
- Retirement Planning, Financial Independence and Spending down money – My deep dive into how much you need to achieve these, and the different ways you can be financially free
- Providend – Where I used to work doing research. Fee-Only Advisory. No Commissions. Financial Independence Advisers and Retirement Specialists. No charge for the first meeting to understand how it works
- Havend – Where I currently work. We wish to deliver commission-based insurance advice in a better way.
- How to Select a Smartphone with A Decently Long Battery Life (That is not an Apple or Samsung Flagship Phone). - February 28, 2024
- 99% of CPF Members Attain Less Than 4 Times Their CPF BRS When They Turn 55. How True is This? - February 25, 2024
- New 6-Month Singapore T-Bill Yield in End-February 2024 to be Lower at 3.55% (for the Singaporean Savers) - February 22, 2024