Video Update: What’s Going on With Bonds?

Bonds are making headlines again.

Treasury bond yields just hit their highest levels since 2007.

So what’s going on and what does it mean?

At Fortress, we include bonds as an essential component of our portfolio. They’re meant to hedge us against volatility in the stock market as part of a healthy portfolio allocation model.

Today, Chief Analyst Adam Galas dives into the various hedges we include in our portfolio. He’ll tell you what’s causing this commotion around bonds and how our hedges have been performing amid the recent market volatility.

Click below to watch the video or scroll down to read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome, Fortress Portfolio members, to a special bond edition of our weekly video update.

Now, I know what you're thinking – bonds are boring… as about exciting as watching paint dry.

Well, that's not actually true.

I'm here to explain to you why they are the most important thing in the world.

Bonds are back, baby.

I'm going make them sexy and explain to you why they are such an essential component of the Fortress Portfolio.

So first, let's talk about the “bond vigilantes”.

You might have heard this term if you've been watching Bloomberg or CNBC or just reading some articles online.

Last Thursday, you might have noticed that stocks fell about 1%. And this was out of the clear blue.

They had been up nicely. And then they suddenly – boom – dropped like a rock.

Why? Because of a $20 billion Treasury bond auction last Thursday.

The government periodically sells bonds. 10-years, 30-years, 2-years… whatever it needs to sell.

And it puts bonds up at auction and sees what kind of demand there is… then that demand sets the interest rates.

Now, last Thursday, demand was much weaker than expected.

The government ended up selling these $20 billion in 30-year bonds at 4.83%.

And of course, now they’ve soared even higher above 4.9%.

But what shocked Wall Street and really sent interest rates up as much as 0.2% in a single day (more than 4% increase in yield), was the fact that bonds traded like penny stocks or crypto.

What happened was that 18% of those bonds had to be bought by the bank.

Because they could not find buyers.

So what's going on? Well, the theory is that right now there's so much uncertainty about what's going on in D.C., the deficit, and the lack of a speaker.

People are wondering if we can keep the government open. There is just a lot of uncertainty.

And what's more, looking at the economy, right now retail sales are coming in much hotter than expected – in fact, three times stronger than expected.

Now, it turns out one reason for this is the excess savings from the pandemic. The previous estimate for those savings recently increased by $750 billion, roughly an extra five months of consumer spending.

What this means, is that the economy is still much too hot.

And so – the fear is that if the Fed cannot get inflation under control, we might be stuck for several years with higher inflation for longer.

And as JPMorgan points out, if inflation does end up getting stuck at 3% or 4%, then potentially interest rates could end up going much, much higher.

So let's talk about what's been going on with the bond market.

Now, if you paid attention in the last few weeks to these updates, we've talked about how in the last three months interest rates are up at the fastest rate in over 20 years.

So what's going on? Well, think back across the pond to our cousins in the U.K. in September of 2022.

Remember, Liz Truss became Prime Minister and she came out with this bold economic plan.

The U.K. would fight inflation by cutting taxes and subsidizing people – so spend more and cut taxes.

Now, the U.K. spent $500 billion on pandemic stimulus.

Adjusting for population, that would have been $2.5 trillion for the U.S. (We actually spent about twice as much, but the U.K. spent a lot of money.)

And now their government came out and said (I’m paraphrasing), “Yeah, the heck with fiscal responsibility. Let's just borrow and spend.”

Well, the bond market was having none of it.

In two days, the 50-year U.K. Treasury, which they call Gilt, fell by as much as 50%.

You might have seen headlines about how the pension system was melting down.

The Bank of England had to step in, even though it was still raising rates.

It had to start buying bonds. Otherwise, the pension system was going to melt down.

The economy was going to melt down.

Well, nothing this extreme is expected to happen in the U.S.

But in the U.K., the government was toppled within six weeks.

Lizz Truss resigned 44 days into her term as Prime Minister.

This would be the same as the President of the United States resigning 44 days after being elected.

This is the power of the bond market. Even if the government is unwilling to be fiscally responsible, sometimes the bond market just forces it on them and can even lead to brand new government leaders.

As you can see below, the problem in the U.S. is that our national interest and our national debt are soaring. The interest expense we are paying as a nation on our national debt doubled in the last 18 months or so.

(Source: Charlie Bilello)

Now, you might be wondering… why?

Corporations like Microsoft were bingeing on 10, 20, 30-year bonds at 1% interest rates… like so many other corporations.

Didn’t the government sell a bunch of 30-year bonds to fund itself… locking in the lowest interest rates in history? As low as 0.8% for 30 years?

Well, no, for whatever reason, they didn't.

In fact, 35% of all U.S. bonds are maturing by 2025 and about 40% by 2026.

That’s when interest rates are expected to remain higher for longer.

So we're basically replacing money that we were borrowing at -1.2%, adjusted for inflation, and now it's costing around 2.5% and climbing.

So what does that actually mean?

Well, just looking at the actual interest rates on the bonds, money was 0.5% for the government's borrowing costs in the pandemic. Now it’s 5.5%.

That's a 1,000% increase.

Now, of course, what is the problem?

Well, as you can see below, the Congressional Budget Office (CBO) estimates that by 2026, interest will be the biggest budget item for the government.

And by 2029 or 2030, it'll hit 3.2%.

(Source: The Daily Shot)

A brand-new record as a percentage of GDP, meaning basically $1 out of every $30 that our economy generates will go to servicing the national debt.

Now, what's scary about this is that this chart estimates 2.9% long-term borrowing costs.

On that note, I am going to show you another chart.

Below is the Congressional Budget Office’s 30-year forecast out to 2053.

And we can see that the interest is expected to be about 6.4% with between 2044 and 2053.

(Source: Congressional Budget Office)

And rising to around 8% to 8.5%, 30 years from now.

And again, this is with 3% borrowing costs – or about $1 in $12 that our economy generates going to servicing the interest on our debt.

Now, of course, we've talked about why this is a worst-case scenario.

This kind of extrapolation is not actually going to happen.

We will fix this.

But of course, it is going to be very messy.

So what does this actually mean for your Fortress Portfolio?

Let’s address our bond disaster – our 30-year headed to 5.5% as Bill Ackman recently said it might.

Or they could reach even 6% or 7% or higher double digits.

Wow, how bad could it be?

Well, the good news is – that while this is the worst bond bear market in history – we are not likely to see a multidecade doomsday scenario for bonds similar to what we saw with the Japanese stock market. They are in year 44 of their bear market and counting…

And here's why we will not see a multidecade scenario... a recession is up and coming that will get us out of that scenario.

As you can see, the bond market is currently estimating 94% chance of a recession next year, starting around June or July.

(Source: CME Group)

That's why they expect the Fed to start cutting, even though the Fed says, they don't expect to start cutting until at least November.

The probability of course, changes all the time.

Yesterday, there were estimating a 96% chance of a recession. A few months ago, they were estimating 100%.

But the point is, this is what the bond market expects.

And this is consistent with our own economic model based on 18 economic indicators that have correctly predicted every recession in the last 30 years.

Our model says that these estimates from the bond market are approximately reasonable.

So what does that likely mean? A 94% chance of recession.

And what does that actually mean for our bonds? The 25-year zero-coupon bonds?

Well, as you can see below, the copper to gold ratio generally tends to track very closely with the 10-year Treasury bond.

And right now, it's saying that economic fundamentals indicate we are looking at 1.5%.

(Source: YCharts)

That's where 10-year yields should be.

That'd be about 1.75% for the 30-year yield, meaning that when the economy finally does roll over into a recession, 1.75% is where the 30-year yields will end up.

Now, what would that actually mean for zero-coupon bonds?

Well, that would be the mother of all bond rallies. In fact, it would be about 106% potential gains for zero-coupon bonds in roughly the next 12 to 18 months.

Now, what if there is no recession? After all, this is the most anticipated recession in history and we've been expecting it for close to two years now.

Well, in that case, the 50-year average, 2% real yield (the interest rate minus inflation rate), would likely be fair value.

This would mean 30-year yields of 4.31%, according to the bond market.

Well, right now we're looking at close to 5% on the 30-year yield, meaning we're looking at between a 16% and 20% rally… even if there is no recession.

That is how much of a coiled spring undervalued bonds are right now.

And of course, they're paying about 5% for long term, which is a fantastic 2.5% inflation adjusted return for zero risk.

Now, as you can see, our managed futures have not done what we hoped they would have, which is to hedge the bonds in our portfolio.

They're down about four times less than others, but still, it's a bit disappointing.

(Source: YCharts)

Now, you might be wondering why is that?

Well, remember what's happened this year?

We started the year with a red-hot jobs report.

Suddenly the story is a no landing scenario.

Boom, interest rates taking off.

Then the Fed is talking about hiking to 6% interest rates right before SVB (Silicon Valley Bank) goes belly up, leading to a banking crisis.

Suddenly bonds rally the strongest in over 40 years.

But then the economy takes off once again. Stays stronger than expected.

Recently, inflation remained sticky... for three straight months it's been rising.

And suddenly we're back to a soft landing. So now higher inflation for longer.

Bonds are going up, but – boom – Israel and Hamas are now at war.

So last week, bond yields plunged, and bonds rallied.

But then the CPI jobs report came in.

And as we talked about, then came the very disappointing bond auction on Thursday.

So basically, the bond market doesn't know what the heck is going on.

It's no landing, soft landing, hard landing. It changes day to day.

But notice that some of our recommendations, such as Altria Group (MO) – is flat… Enterprise Products (EPD) is up 15%... ONEOK (OKE) is up almost 6%.

So, you can see this is the power of the diversified portfolio.

We have seen the worst bond bear market this year in U.S. history.

And we have seen bond volatility higher than in the Great Recession and the pandemic.

This is truly unprecedented – bond yields trading like crypto and penny stocks.

It is something that no one has ever seen before.

And yet take a look at Fortress, basically flat for the year, just like most of its peers, even the Invesco S&P 500 Equal Weighted ETF.  

(Source: Fortress Portfolio YTD Performance via Portfolio Visualizer Premium)

Remember that the magnificent seven things like Microsoft, Amazon, Google, and Apple… these are the ones driving the market higher this year.

Basically, these are stocks trading at 35 times earnings and nearly 50% historical premium.

So do not go chasing that momentum, especially if interest rates are more likely to keep rising until we finally get that recession.

Remember, the Fed always hikes until something breaks.

At some point something is going to break.

But take a look at this…

What are the two most interest rate sensitive sectors? Those would be health care and I.T. – technology.

(Source: The Daily Shot)

What are the least sensitive sectors?

Consumer staples like Altria Group (MO). Utilities like Brookfield Renewable Corp (BEPC). Energy, like all of our pipelines… and financials, the least rate sensitive sector of all.

All told, we're invested in about 95% of these low-rate sensitivity stocks.

What's more, your Fortress Portfolio is yielding 7.4% right now and has a price to earnings ratio of 8.4.

That means it's priced for -0.2% growth.

And for context, the S&P bottomed at 11.5 times earnings in March of 2009.

Remember, that was the second biggest market crash in history, the second biggest economic catastrophe at the time since the Great Depression.

Today, the S&P is at 18.5 times earnings.

The Nasdaq is at 23 times earnings.

And as we already talked about, the magnificent seven are at 35 times earnings.

So a 7.5% yield is an incredible discount to fair value. This is literally a 26% historical discount priced for negative growth.

But what do we and analysts actually expect? We expect 7% growth.

So even though the hedge is completely failing, we are basically sitting on a flat portfolio that's raking in the cash.

And over the last five years those dividends have been growing at 6%, which is 1.5% faster than inflation.

And remember that inflation is the highest it's been in 42 years.

Now, long term, if you're buying today, you're looking at around 14% to 15% returns on the stock portion… and adjusting for the hedges, around 11% to 12%.

But thanks to that discount to fair value, that's roughly an extra 3% per year for the next decade, meaning 14% to 15% expected returns for the next decade.

That is basically quadruple your money in the next ten years.

The S&P is expected to go up about 160%.

Now, to give you some context, in the last decade, S&P is up about 15% annually in an era of zero interest rates… when tech was going crazy and people thought there was no price too high to pay for the latest tech trend.

Well, here at Fortress Portfolio, we have coiled springs trading at 8.5 times earnings.

For context, right now, people like Mark Cuban, who is in private equity, and other billionaires are getting sweetheart deals… paying 11 times earnings.

These are deals that nobody else can get.

But we're getting them at 8.5 times times earnings buying right now.

Because we know how to find the world's best blue chips at the best deals so that we can set you up for Nasdaq beating returns while you swim in safe dividends.

We want you to sleep well at night no matter what's going on in these unprecedented times… D.C. drama, geopolitics, it doesn't matter.

We have you set up for a safe and comfortable retirement so you can reach your dreams.

Thank you for joining us this week.

Next week we’re going to talk about the jobs report (another blowout) and what it means for the economy, for the recession, and your Fortress Portfolio.

But until then, please send us your questions, comments, and feedback so I can respond to them in these videos and our monthly issues.

Just remember, I can't legally provide personalized investment advice.

Until next week, this is Adam Galas, wishing you and your family safe investing and a healthy, relaxing, and joyous weekend.