Brightwater Advisory

The 4%+ Bond Market – Opportunity or Risk?

by David Maddux, CEO | CIO

We sent the following note to clients that was written on January 24th.

The 4%+ Bond Market – Opportunity or Risk?

Summary:

Risk free treasury bonds are attractive any way I look at them and we continue to prefer a laddered approach in case inflation creeps higher again;

Stocks exceeded their highs of 2021, but earnings have not kept up (they were $197 for the SP500 in 2021 and appear to have ended 2024 at $210) so they are even more over-valued by traditional fundamental metrics (price to earnings ratio of 24 in 2021 and now 28 – lower is better, per Ned Davis Research);

Purpose of Investing – good investing is boring by design – serenity over anxiety;

Brightwater Model portfolio – valuations and posture;

Cyber-security – “Smishing;”

Trusted Contact;

We all need community.

My letter three years ago was about how the interest rate environment was changing and that was likely to affect aspects of the economy and other markets, like stocks.

That kind of happened. Stocks ended up having a lousy 2022, but then recovered in 2023 and broadly set new price highs in 2024. All the while, the economy never dropped into a recession as the rate of inflation gradually came down.

The full impact of higher borrowing costs seems like it has not been felt yet though. This leads me to remain on notice for a drag on the economy and other growth assets like stocks.

Today, the Federal Reserve has cut interest rates three times since September from 5.33% to 4.33%, but the interest rate on the five year treasury bond has moved up over that same time period from 3.4% to 4.4%.

Why that is can be another line of discussion, which is interesting and worthwhile to think through, but for now I am highlighting that medium and longer term interest rates are not going down, in spite of the Federal Reserve reducing their short term, daily rate, a.k.a. “the Fed funds rate.”

The implications for me are two-fold –

Absolute basis – Risk free bonds are attractive based on their history (both nominally and when considering current inflation measures) and worth locking in;
Relative basis – Risk free bonds paying 4.4% is higher than the earnings yield on US stocks (SP 500) at 3.5%, as stocks are currently priced in their highest decile of historical valuations (Cypress Capital).

I went back ~100 years (from Ned Davis Research) to bucket the 10 year treasury bond (getting to be long term vs. 5 year, but not as long as a traditional 30 year mortgage) into what interest rate was reflected most of the time for each decade (median).

The average over time was 4.8% with the 1970’s, 1980’s and 1990’s showing the highest decades. The lowest were the 1940’s and the decade we just transitioned from. If I drop the highest and the lowest decade from the mix, then the average median is 4.4%. My illustration is to clip the extremes somewhat to see if it makes any difference, but it really does not – rates are fairly priced from this simplistic, historical look.

Absolutely

The implication is that today a risk free interest rate is available for where it has been most of the time over 100 years of booms, busts, wars, new political regimes, etc.

Can interest rates go higher because of inflationary pressures, continued deficit spending, hot economy, tariffs, trade wars, wars, etc? For sure. That has not been conventional thinking and I do not have conviction to make that case, but the way we allow for that is to use a ladder with individual maturities where a piece of the bond portfolio is designed to come due this year, next year, etc. This approach allows some agnosticism on shorter term outcomes, but also flexibility to ratchet up the interest rate we are locking in if rates work higher the next couple of years.

Today the average maturity for our model bond sleeve is ~3.5 years and paying in the mid-4%.

Can rates go back down into the 2% range or lower? Yes. That would not matter in the very short-term though, as we have locked rates for a few years. The implication is that there is little benefit to sitting too heavily in cash/money markets today vs. the 5 year treasury bond market. For example, if rates move lower to 3% or 2% then a money market rate will drift lower in synch, where as a 5 year bond locks in the current rate of 4.4% for the duration of the five years and should be an easy asset to swap out if need be. Again, a ladder helps here, as there are shorter term maturities coming due over the next one year, two years, etc.

This context is a completely different setup than four and eight years ago for example when the medium term treasury market was paying 1% and money markets were effectively 0%. Cash was a much better position to be in, because if you were in a 1% five year bond and rates move up from there, you are having to sell your bond at a loss in order to buy stocks or fund an unplanned distribution. The challenging part was psychologically holding cash that paid nothing, as us old-timers were trained to get interest on our money.

Finally, if rates come down, we may wish that we had locked them in for even longer, but the more complex implication is that would likely come with an economic recession and stock prices being dramatically lower. This would present a fresh opportunity to move some of the bond portion over to stocks for attractive expected growth from that point going forward.

Finally, finally – most every financial plan we have run for clients works much easier when risk free rates are paying anything north of 4%. Everyone is unique, but simple algebra just means that risk free rates in that range relieve pressure off of the required return for stocks to pull their weight, as well as the heavy lifting for additional savings or longer years working for money.

Relatively

I just made the case that risk free bonds are yielding rates at their average levels over 100 years (i.e. not on the highest nor lowest side), but I cannot say the same about the stock market. Certainly stocks can work higher the next few years, but the margin for error is razor thin. Whether measuring them by classic ratios of price vs. the profits or earnings of the underlying companies (PE), price vs. the revenues or sales of the underlying companies (PS) or price vs. the cash-flows of the underlying companies (P-CF), the context is that valuations are in the highest decile of where they have traded over the last 100 years (Cypress Capital). Eg – stocks were overvalued three years ago and are now more egregiously so. The pathways to “fair” value again are 1) prices hangout while earnings grow in the coming years, 2) stock prices go down to align with earnings or 3) some combination thereof.

Positives for earnings should be lower interest rates as well a continued lower Federal government tax policy, but again the tension is how much of that expectation is baked into prices.

I can wax optimistically on some areas being fairly valued vs. overvalued or durable sector themes like Artificial Intelligence (AI), healthcare around the possibilities and disruption of weightloss drugs or the movement toward investing in sustainability, but broadly speaking stock valuations are at the highest decile of historical valuations, while bonds trade at the middle of their historical valuations and the bond market is paying better than the stock market on comparable measures.

Specifically, the dividend yield on US stocks (SP 500) is 1.2% and the earnings yield is 3.5% (which includes the dividend payout by definition as dividends are funded by earnings) is lower than the risk free 4.4% available in the 5 year treasury bond market.

The Purpose of Investing – Serenity over Anxiety

I have been re-reading a classic investing narrative entitled The Money Game written by “Adam Smith” (pseudonym) in 1967 during the melt up in the “Nifty Fifty” stocks (Polaroid, Avon, Eastman Kodak, Sears, Xeros, etc), which were the “must own” stocks of that era, as they performed fabulously. . . until they didn’t.

The narrator of The Money Game reflects,

“No matter what role the investor has started with, in a climax on one side or the other, the role melts into the crowd role of fear or greed. The only real protection against all the vagaries of identity-playing, and against the final role of being part of the crowd when it stampedes, is to have an identity so firm it is not influenced by all the brouhaha in the marketplace…

Nothing works all the time and in all kinds of markets. This is what is wrong with systems and the books that tell you You Can Make a Million Dollars. What is important to realize is that the Game is seductive. If playing it has been fun, it may be difficult to stop playing, even when that button of yours is burning your finger. Repeated shocks will give you anxiety, and anxiety is the enemy of identity, and without identity there is no serenity.”

My point here is to foster awareness of what is the purpose of investing. The obvious is to make money, but it can be challenging to resist over-owning assetst that have performed the best in recent years (stocks) vs. those that have been less exciting and possibly over-looked (risk free government bonds).

Valuation & Posture

Economically, there is an imbedded expectation that Trump’s pro-growth and government efficiency initiatives will be a positive. Assuming they are, his latest term is starting out with the most over-valued stock market in US history, which is not a specific negative, as much as reflective that a lot of optimism is priced into the stock market and there is not much margin for error – or said another way, risk levels are high.

The following matrix reflects our Brightwater Equity model vs. the All Cap World Index, which comprises 67% US and 33% international, as well as the S&P 500, which is an index of the stocks of the largest US publicly traded companies. By comparison, the Brightwater portfolio remains more fairly valued compared to these indices –

I am still on notice that the full effect of higher rates has not been fully experienced yet. Basic examples for individuals are –

mortgages (6.6% average for a 30 year per Zillow vs. almost half that rate in the years leading up to 2023);
car loans (6.6% average for a new car per NerdWallet);
credit cards (24.2% average per LendingTree).

For main street and the average publicly traded company it’s a somewhat different lens, as a borrowing proxy is only 5.5% (BBB rate per Federal Reserve Bank of St. Louis) which is only ~1% higher than risk free treasury rates. The average difference over time has been closer to 2.0% (Ycharts) and another contextual point is that personal bankruptcy filings are at 18 year highs (Cypress Capital). Again, the economy has been okay by most measures, but different measures of risk seem mispriced with little margin for error.

More from “Adam Smith” –

“…An investment counselor wrote a very interesting essay on investing and anxiety, for anxiety is the threat to identify. . . The end object of investment is serenity, and serenity can only be achieved by the avoidance of anxiety, and to avoid anxiety you have to know who you are and what you’re doing.”

We have a section on the first page following the Table of Contents on your Investment Plan Portfolio report in which we share our Investment Guidelines (the left panel is an attempt to periodically update custom notes on your moving parts) and one of them addresses –

“If the stock market declines from its highs, we intend periodically to re-balance your portfolio back to your target percentages in stocks. To do so involves using some of the bonds and cash to add to stocks, which may go lower still, but this process is a methodical way to add to stocks during down periods.”

Per my note in October, our average client is about 10% underweight her stock target, so a 60% allocation to stocks is more like 54% as a mild erring on the conservative side.

I do not know what the future holds, but we are focused on what we can control, which in this case is implementing a simple, yet robust investment portfolio that barbells risk free interest rates on one end and long term growth or price appreciation on the other end, rooted in stocks that are fairly priced vs. over-priced. This approach is adjusted for each client to fit with her season or unique circumstances.

This approach fosters flexibility to address opportunities and challenges as they present themselves and hopefully, serenity.

Housekeeping

Cybersecurity – “smishing”

Charles Schwab has alerted us of an active phishing text or SMS campaign in which clients receive a text message from an international number and it mentions a disbursement from the client’s account. It then asks to click on a link to log into their account to verify the transaction. Please review the red flags below to help clients identify if the text is a phishing attempt:

The texts are coming from different international phone numbers.
The texts notify that an ACH was debited from their Schwab account, typically in the thousands of dollars.
The text then instructs the client to cancel the disbursement if they did not request it, by replying “Y” and clicking on the link provided.
The link’s URL is a variation of a spoofed Schwab domain. For example https://schwbba.com, https://schwabd.com, https://schwbab.com, etc.

My understanding is that Schwab has so many customers that the campaign is random as opposed to a targeted data breach. As I remind myself, family, team and clients – basic security rules that I have come to understand are –

Use two-factor authentication on your email account, because that inbox is usually the link to any password resets on bank accounts, etc., etc;
Do not click on links regarding financial accounts. It is best to navigate directly to the website you are looking to go to.

Trusted Contact

A “trusted contact” is a person you authorize Brightwater Advisory and Schwab to contact at their discretion to disclose information about your account(s) to address possible activities that might indicate financial exploitation of you; to confirm the specifics of your current contact information, health status, (including physical or mental capacity), or the identity of any legal guardian, executor, trustee, or holder of a power of attorney on your account(s).

A trusted contact will not be able to view your account information, execute transactions in your accounts, or inquire about account activity unless that person has that authority through another role on the accounts, such as a trustee or power of attorney.

If you would like to add a trusted contact to your Schwab accounts and your Brightwater profile, please contact us to send you the form to update per your request.

Community – As the Formula for Fulfillment

Maybe it is because I am turning 50 this year and kid #1 of 3 shipped off to college, I am particularly reflective of late, but I keep picking up on signals from the universe about the critical role that community plays in our personal health. Recently, a friend of a friend shared “My Parting Prescription for America” by the 19^th & 21^st Surgeon General of the United States, Dr. Vivek Murthy, and I am compelled to quote his opening section in full –

“My father once told me that he never felt a sense of emptiness—that painful, gnawing sense that something is missing—until he left his village in India. It was a remarkable statement from a man who grew up with no running water or electricity, and whose family scarcely had enough money to put food on the table each night.

Yet what they lacked in wealth, they made up for in community. Families looked out for each other. If you went by someone’s house, they invited you in to share whatever food they had. When my father lost his mother to tuberculosis when he was 10, the village stepped in to help my grandfather and his six children. Friends and extended family became surrogate parents.

Against all odds, and bolstered by the support of his village, my father went on to study medicine. Medical school lectures and hospital rotations never taught him about the power of community. But his patients did, first in India and then later in the United States. Through their lives, he quickly came to see that community was a potent source of health and well-being. He observed that you could eat well, exercise, sleep eight hours a night, and have all the right vital signs, lab tests, and imaging studies. But without community, it was hard to feel whole.

My parents were grateful for the chance to make America their home, yet they missed that sense of community so much that they made sure to teach my sister and me about its importance as we grew up. Every time they visited a friend who lost a loved one or brought over food when someone was sick, they demonstrated to us the value of showing up for others. By surrounding our family with friends who never needed us to say or do anything special, they taught us the power of being around people who allow you to be unabashedly yourself. And through their care for patients over the years—which involved everything from house calls to hospital visits to late-night phone conversations when someone fell ill—they reminded us that when we find our purpose in contributing to the lives of others, life isn’t always easy, but it is immensely gratifying.

Over time, I came to appreciate that my parents weren’t teaching me how to build community—they were giving me the formula for fulfillment and well-being.

Why? Because community is a powerful source of life satisfaction and life expectancy. It’s where we know each other, help each other, and find purpose in contributing to each other’s lives.

These core pillars of community—relationships, service, and purpose—are powerful drivers of fulfillment. They can also significantly influence health outcomes, including premature mortality, heart disease, depression, and anxiety. Community also gives us strength and resilience when facing the big challenges and countless paper cuts that come with moving through the world.

We don’t have to be fulfilled in every way by one single community. Most of us need a few different communities in our lives to make us feel whole. And communities don’t have to be static; they can evolve and overlap, like when parents from our child’s school become part of our softball league or join our congregation.

Some of the most enduring lessons about community can be found in faith and cultural traditions across the world. The teachings of Christianity ask us to love our neighbor as ourselves, and the Hindu scriptures guide us to care for our guests as we would care for the Divine. The Jewish emphasis on Hesed, loving-kindness, is a reminder of our obligation to be there for and care for each other, and the Muslim pillar of Zakat enshrines the importance of lifting up others through charity. The South African philosophy of Ubuntu—often translated as ‘I am, because we are’—emphasizes our interdependence and responsibility to one another as human beings.

These are clear, consistent, and time-tested calls to cultivate community for our individual and collective well-being.”

I encourage you to read the full reflection, which was released on January 7, 2025. As well, I invite you to hold me accountable. One of my takeaways is to have lunch with each of my neighbors that lives on our street. We fortunately have a friendly street, but time passes and we are all coming and going. There are at least 21 men, so It should be a good exercise. Please ask me this time next year if I accomplished this goal and how it went.

I hope 2025 is off to a good start for you and look forward to comparing notes when the opportunity allows.

Sources:

Morningstar Research provided the portfolio analytics

Ned Davis Research

This letter is tonal in nature. We use model portfolios and apply consistent thinking, but each client has a separate account and there are many reasons for exceptions, like tax basis, heirloom holdings, preferences, size of the account, etc.

Data source for stock market proxies and representative portfolios: Morningstar Office. Definitions for the metrics referenced can be found in the glossary toward the end of your Investment Plan Portfolio Summary.

Brightwater Advisory, LLC is an SEC registered investment adviser* with its principal place of business in Tampa, Florida. This letter contains general information pertaining to our advisory services. The information is not suitable for everyone and should not be construed as personalized investment advice. This letter contains certain forward‐looking statements (which may be signaled by words such as “believe,” “expect” or “anticipate”) which indicate future possibilities. Due to known and unknown risks, other uncertainties and factors, actual results may differ materially from the expectations portrayed in such forward‐looking statements. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing involves risk, including risk of loss, which an investor must be prepared to bear. We manage investments based upon factors which may include, but are not limited to, a client’s investment time horizon, income, net worth, attitude toward risk and investment knowledge. Therefore, it is important for clients to inform us promptly if there is a substantive change to his or her risk capacity, including financial situation. In addition, if goals and objectives have changed, please let us know immediately. Indices are unmanaged. Any reference to a market index is included for illustrative purposes only as it is not possible to directly invest in an index.

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