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Alternatives to Bonds FAQ

May 2015

by Jan B. Brzeski

In April 2015 Warren Buffett declared that "bonds are very overvalued". Given that bonds are the world's single largest asset class, and Buffett's well-earned reputation as the leading thinker on investing, investors of all stripes will spend the coming months and years trying to find good alternatives to bonds.

This frequently asked questions (FAQ) page attempts to provide insight into Buffett's declaration, and to de-mystify alternatives to bonds, also known as "fixed income investments."

What are bonds?

Bonds are essentially loans from investors to companies, governments or other institutional borrowers. When a company or government issues a bond, it is promising to pay an interest rate that is usually a fixed amount each month or quarter, and to repay the bondholders their principal at maturity of the bonds.

Why are bonds so popular with investors?

Bonds are popular with investors because they are usually safer and less volatile than equity investments such as shares in a public company. Bonds have traditionally been considered as the cornerstone of every portfolio, particularly for risk-averse investors. In fact, bonds issued by the US Treasury have set the standard for the least risky investment available (though some would argue that today the risk of a default by the US government at some point in the future is real. 

Why do borrowers like issuing bonds?

Borrowers like bonds because they can raise money without giving up any ownership of their underlying assets or equity. When Apple sells $1 billion of bonds, it can invest that $1 billion into its business, without giving up any ownership in the company. Typically bonds are a cost-effective way to finance business investments.

Why does Warren Buffett believe that bonds are very overvalued?

Warren Buffett likes to buy things when nobody else wants to own them. One of his sayings is "Be fearful when others are greedy and greedy when others are fearful." He believes that investors are overly optimistic about the future value of bonds. In short, he expects bond values to drop.

Why might bond values drop in the coming months and years?

Bond values increase when interest rates fall, and they decrease when interest rates rise. For about the past 40 years, interest rates have been on a downward trend (putting aside a few periods when they rose temporarily before dropping even further). Quite simply, with interest rates near zero in most developed economies, there is nowhere for interest rates to go but up. When they do go up, bond values will drop and bond investors who thought they owned a "safe investment" will find that they have lost money.

What could cause interest rates to rise?

Since the financial crisis, the United States government has spent trillions of dollars more than it has taken in from taxes. It has covered its budget deficits by issuing bonds which were purchased by domestic and overseas investors, including foreign governments such as China. Suppose that China lost confidence in the future of the US economy and started to worry that, like Greece, the US had simply taken on more debt than it could pay back. If China and other large investors stopped buying US bonds, interest rates would immediately spike upward.There is nothing supporting today's ultralow interest rates other than confidence that the US government will eventually stop borrower money and start focusing on paying back the money it borrowed in the past. That confidence could evaporate in several years, or it could disappear much more quickly if there were some trigger event that made people start to worry about risks to the United States economy.

How will the US deal with all the debt it has taken on?

It seems unlikely that the US government will slow down its spending or raise taxes dramatically, unless it is forced to do so. There is no will in Washington DC to raise taxes or cut benefits such as Social Security or Medicare, because voters punish politicians who try to do these unpopular types of things. There is one convenient alternative for politicians--printing lots of money to pay our bills. The Nobel Prize-winning economist Milton Friedman wrote about "dropping money from helicopters."

What would happen if the US Treasury dropped trillions of dollars from helicopters?

Imagine the scene--helicopters flying over your neighborhood, dropping $100 bills. People would be in the streets fighting over the money and collecting as much as they could of course! Once the battle was over, suppose each family had an extra $100,000 of cash in their mattresses. Many people would start to spend money on things they really wanted or needed, but couldn't afford before. Other families with two working parents might decide that one person could stay at home most of the time instead of working. Others might pay off debt or invest the money. What would happen to apartment rents if every family had an extra $100,000? What if every family had an extra $500,000? At some point, people would start offering a lot more to get what they wanted. In other words, the buying power of a dollar would decrease--in other words, we would experience a bout of dramatic inflation. Right now people are more worried about deflation than inflation. However, if the government ever did feel that the national debt had become out of control, you can bet they would prefer to print money (which is essentially like dropping bills from helicopters) rather than telling voters that their taxes were going to increase sharply and that they could no longer get their trash picked up every week.

What happens to the value of bonds if there is inflation?

Suppose you purchase a 10-year government bond. As of late May 2015, you would receive an interest rate of 2.21% per year, in other words, about $2,210 per year for every $100,000 of bonds you bought. At the end of the 10 years you would receive your original $100,000 back (question: do you think the government would give you your money back to raising taxes by $100,000, or by creating more bonds and hoping they could find new investors to pay you off?). Today, investors are okay with a 2.21% total return on this investment. But what if the became concerned about dramatic inflation? In the early 1980s, the 10 year Treasury at one point yielded more than 15%. That's what happens when people become worried about inflation.

What happens to the value of a five or ten year bond when interest rates rise?

If interest rates on the 10-year Treasury bond moved up 1%, from about 2.2% to about 3.2%, the value of a 10-year Treasury that you purchased from the government yesterday would drop dramatically. Specifically, it would drop by something like 10%. Your $100,000 investment would suddenly be worth more like $90,000. If you are only getting $2,200 per year in interest payments, you can see that buying bonds can be a risky proposition today. Now imagine if interest rates moved from 2.2% to 5.2%. This would wipe out a large portion of your savings. Now consider that the 10-year Treasury bond yielded above 5% for about 30 years, during the 1970s, 80s and 90s. It spent more time yielding above 5% in the past 50 years than yielding below 5%. In other words, once interest rates start climbing, they may not come back down for decades. Money lost from holding bonds in the coming years is likely money that will never be recovered in your lifetime. This is what Warren Buffett is talking about, when he says bonds today are "very overvalued."

So what options do investors have, if they are afraid of holding bonds?

This is the $64,000 question in the world of investing today! Each day the Wall Street Journal is filled with tens of thousands of words and dozens of articles, and yet there is no topic more important to global investors than this simple question--what can investors do with that portion of their portfolio that needs to generate investment income, and that they cannot afford to lose? In our view, there is very little written about this topic because none of the established investing experts have anything insightful to say about this topic.

Why do the established experts on investment have so little to say about alternatives to bonds?

Let's take BlackRock--one of the most respected investment management companies in the world, with about $4.8 trillion in assets under management in 2015. They have actually made an admirable effort to educate investors about the risks of traditional bond investment strategies, given all the issues described above, under the umbrella of their marketing slogan "time to rethink your bonds". The problem for BlackRock and other leading bond investment groups is that they manage so much money, there is no way for them to avoid putting the bulk of their fixed income (low-risk) assets into bonds. They can recognize the risks in bonds, and they try to diversify into other assets like perhaps preferred equity, or overseas bonds they offer higher yield, or participating in loans to smaller companies that are not large enough to issue bonds. But how can they put trillions of dollars to work, without huge amounts ending up in bonds?

What is the best alternative to bonds today?

We at Arixa Capital are excited to be part of the conversation about alternatives to bonds. Since early 2010, we have been managing money for investors who want significant current income without taking on excessive risk of losing principal, by making loans secured by real estate to small developers. With over 400 investments under our belt, and steady returns in our audited track record, we think we can contribute to this important dialogue. We believe this single best alternative to bonds today is small balance loans to small businesses, secured by real assets. Let's take a look at each part of this proposed answer to the questions raised or implied by Warren Buffett's recent remarks.

Why loans?

Remember that bonds are essentially loans, and that their role is to provide steady income without putting your principal at risk. While one could conceivably transition out of bonds into buying stocks, this may create excessive volatility for many investors. We are talking about the broad base of your portfolio, not the "mad money" that you might invest in venture capital or other high-risk, potentially high return assets. If you want less exposure to bonds, stick with something that is bond-like but with less risk and higher income--if you can find it.

Why small balance?

Large well-established businesses can borrow at incredibly low interest rates. If you are the CFO of Apple, Google or General Electric, you will find dozens of banks, foreign governments and everyday investors willing to give you their money at rates close to the yield on government bonds. And if you could borrow at, say 3% per year for a 10-year loan, why not do so, versus borrowing for, say 6 months (which large companies also do) and having to worry about rolling over these shorter term loans regularly. If you are the owner of a small business--even a well-established and successful one, your options are much more limited. It is very likely that you can't get any bank to lend you any meaningful amount of money at all. You may find a bank that will lend you $100,000--so long as you can promise to keep deposits at the bank that average $50,000 to $100,000 at any given time! In other words, you can borrow money at 4%, as long as you keep a similar amount of money tied up at the bank, earning 0.1% interest. The key point is that small companies have been the big losers of regulatory changes since the financial crisis. Banks are not very good at lending money to businesses in increments of tens or hundreds of thousands of dollars. They prefer to lend $10 million, as long as the business has millions of dollars of cash flow per year.

Why loans to small businesses?

Businesses are the lifeblood of the economy. They are famous for creating the great majority of new jobs and even the ones that aren't growing rapidly perform the lion's share of work in our economy, from cleaning houses to making t-shirts to creating websites for other small businesses! If you are trying to make loans, who else are you going to lend to, if not to small businesses? Large businesses and governments are able to borrow at astonishingly low rates of interest, as discussed previously. Non-profits such as churches might also need to borrow, but you probably don't want to be in a position of collecting on a loan from a church that is in default. Lending to individuals can make sense (financial technology companies and marketplaces such as LendingClub are active in this market). However, politicians and judges (at least in California) love to protect "the little guy" from "big bad lenders" so be prepared for choppy waters in case there is a downturn in the economy and you need to collect on a lot of consumer loans. That leaves one group who are willing to pay meaningful interest, who have interesting opportunities needing to be financed, and who are not able to plead ignorance to a judge or a politician when the going gets rough--small businesses.

Why loans secured by real assets?

Real assets fall into two main categories--real property such as land and buildings; and personal property such as trucks, equipment or precious metal. Real assets are attractive as security for a loan for a few reasons. First, they usually have some underlying utility that is independent of their market value. A truck can bring food from the farm, even if the shares of Lehman Brothers are going from $100 to zero in a few days. A house can provide shelter for a family, even if terrorists are creating a crisis somewhere in the world. Second, in the U.S. there is a well-established way to place a lien on real and personal property. In other words, if the loan is not repaid, under the law, the lender is entitled to take the assets. In the case of real property, there is the added benefit that the property cannot be moved. For this reason, the amount of loans secured by real and personal property (for example, homes, commercial real estate, cars, trucks and the like) is much larger than the amount of unsecured loans, which are secured by nothing more than a handshake. A typical family that owns a small business may have thousands of dollars of credit card debt, but they have tens of thousands of dollars of mortgage debt and/or debt secured by vehicles and other personal property.

What happens if a loan goes into default?

We make loans to small real estate developers. We usually lend 75% of a project's hard costs, which works out to about 55-65% of what the property ultimately sells for. If our borrower defaults, we are prepared to take back the underlying property; finish the renovation ourselves; and sell the property to recoup our money. Even if the real estate market is dropping at 1% per month, and it takes us 18 months to foreclose on a loan, finish the project and sell the project, we feel pretty good about the margin of safety of our loans. If we lend $600,000, the underlying home should be worth about $1 million when completed. That's a $400,000 margin of safety. One might call this the "belt and suspenders" approach to investing. The investment could go either way, and unless you make a mistake in your underwriting, you should be able to avoid taking a loss the great majority of the time.

If the answer to Warren Buffett's challenge is small balance loans to small businesses, secured by real assets, then why isn't everybody investing in such loans?

Here is the tricky part--it is not easy to source, originate, service and manage such loans--particularly short-term loans of under 24 months (which are attractive because their value isn't affected as much by increases in interest rates). Banks are not very good at making such loans, which often need to be made quickly and without a lot of red tape, to be useful to the borrower. The best lenders to small business are...other small businesses! And these small private lenders--such as my company, Arixa Capital--are constrained in their ability to grow by a number of factors. Small lenders, like their borrowers, have trouble securing bank financing. They also face challenges in scaling up their businesses to a large size, without losing the entrepreneurial zip that makes them successful in the first place. For investors,finding a way to gain exposure to these attractive lending niches requires a lot of effort, vetting different private lenders, seeing how well they run their operations, and getting comfortable that they will act like fiduciaries and professionals when the going inevitably gets rough.

What is the bottom line when it comes to alternatives to bonds?

If it were easy to find an alternative to bonds, everybody would be doing it. As it stands, the great majority of investors are sitting on extra cash, trying to figure out what to do. Some are employing what Mohamed El-Erian (formerly of Pimco) describes as a barbell strategy--with quite a bit of money in cash and then a lot of money in riskier, more esoteric investments on the other end of the barbell. Over time, money will continue moving out of bonds and flowing into secured lending niches like the ones described in this FAQ. As large Wall Street firms and private equity fund managers target these niches, returns will come down and they will start being less special and will start being more like all the other major asset classes--namely, artificially pricey because of excessively easy money from central banks trying to spur the economy. In the meantime, for investors willing to roll up their sleeves, private lending secured by real assets remains an attractive alternative to bonds and a good place to be in today's overpriced world.