On this episode of The Long View, Cullen Roche, the founder and chief investment officer of Discipline Funds, discusses how trade wars might affect the economy and major asset classes, what Treasury bonds are telling us, and whether investors should be concerned about inflation, recession, or both.

Here are a few highlights from Roche’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

Rethinking Bonds With a Time-Based Strategy

Christine Benz: Can you talk about what kind of holding period you think investors should have in mind if they’re thinking about holding fixed income as a portion of their portfolio?

Cullen Roche: One of the things I love about bonds is that you can slice and dice the time horizon so specifically. And this is the thing that makes stock market investing so hard: You can’t really slice and dice the time horizons of the stock market. There are certain things, like value stocks tend to look like a little shorter-duration instruments. Tech will tend to look like longer-duration instruments. But even so, you’re still talking about multidecade instruments, whether they are 15- or 20-year instruments. But in the bond market, you can slice these things up, down to daily instruments, all the way out to 30-year instruments. One of the interesting things I found when I quantified the defined-duration methodology was that long-term Treasury bonds operate almost more like insurance.

And this actually makes sense from a more fundamental level. They’re so interest-rate-sensitive that they perform best in a deflationary or a recessionary environment. And so they almost operate like an insurance component of a portfolio in these very unusual acute periods. And recessions that deflations are, they’re unusual, they’re not the norm. And so they have, in terms of the way that the actual instrument operates, the long-term Treasury bond will typically generate a low or negative real return. But in these very acute environments, it will have this huge asymmetric return that’s very beneficial to the portfolio. Whereas something like a Treasury bill, you can structure it in a way where this thing is just giving you a very reliable short-term cash flow stream. Bond aggregates have become very popular in the last 20 years. And I used to use nothing but bond aggregates for a lot of my clients in our bond portfolios.

And I started to notice after the financial crisis that these instruments would expose people to an interesting behavioral bias and that not only can you see the price every day, but these instruments, when you mesh everything together, have a constant maturity. And what that means is that, for instance, a bond aggregate has a six- or seven-year constant maturity inside of it. And that doesn’t give people certainty over reliable time periods because the portfolio, by definition, is constantly rolling the new issuance and stuff to maintain this constant maturity over time. And that can be behaviorally difficult because when you go through environments where, for instance, in the last few years, when interest rates rise a lot, it creates a lot of uncertainty where that investor is looking at that thing. And it almost has similar characteristics to stocks. If you thought of the stock market as having this constant maturity of 18 years that I mentioned, well, that creates a huge amount of uncertainty in say five- to 10-year time horizons.

And the bond market is something that people typically look at their bond allocation, they say, “OK, this is the safe part of my portfolio. I want this to be reliable over the short term.” And then you see weeks like last week or years like 2021 and ’22 when the bond market is very volatile, and they say, “Whoa, this is a lot more volatility than I signed up for in my supposedly safe component.” So, I’m a big fan of disaggregating a bond aggregate into its individual components and actually ripping out the individual time horizons. I’m a big advocate of what I call “T-bill and chill,” the strategy of basically taking a T-bill portfolio and turning it into very specific T-bill ladders where you’re taking your T-bills and you’re creating really absolute certainty over zero to 12 months, for instance. And giving people the ability to look at that and say, OK, regardless of what’s happening with the 10-year Treasury bond today, I know that my Treasury bills, they didn’t move at all during all of this, and they’re earning 4.25% right now, and I have absolute certainty of the time horizon over which I’m generating a certain amount of money and I have certainty, most importantly, of the principle over that time horizon.

Why Treasuries Remain the Gold Standard in Global Markets

Lefkovitz: You referenced the drama that we’ve seen in the Treasury market recently, here in April, the yields spiking and the safe-haven status being called into question. Obviously, US debt is a lingering issue. Do you have any concerns that safe-haven status for Treasuries and bonds is at risk?

Roche: I don’t. To some degree, the price action was disconcerting last week, but it’s interesting to put this in perspective because I got a question from a client who asked me, “Should we be buying international bonds?” Because I like to very specifically buy only domestic because my general view is that, well, the US economy and the US government, by virtue of being able to tax the most profitable entities in the world, is the safest entity by definition due to that. And so their liabilities are very reliable because of this income stream that they have from the underlying economy. But I thought it was interesting because since the stock market peaked in the middle of February, the best-performing asset class in terms of the bond market is actually US government bonds. The intermediate bond is up a little over 2.5% as of today since Feb. 18, and international bonds were better-performing last week.

But since the stock market started getting jittery due to the tariff concerns, the US government bond market, the intermediate bonds are the best-performing part of the bond market. And so I do think that some of this is just due to the extreme gyrations. Interest rates went from 4.3% at the end of March, or toward March 25 or so, and they fell to 3.9%. So, they went through this roller-coaster ride where they fell a lot, and then interest rates spiked a lot. And I think a big part of that is foreigners are now going through this rebalancing of their portfolios where they expect there’s going to be less dollars flowing out of the United States. And that means that as the United States kind of closes itself in, the foreigners are going to have less access to the US market. And so, in my view, there’s been this big portfolio rebalancing effect due to that change in the potential future of the current account and the amount of dollars that are outflowing.

And so I don’t view this as a long-term change. The US financial market is still just so much bigger, so much more secure, so much safer than every other financial market that I don’t see a scenario where, for instance, German bunds or Japanese government bonds become close competitors in terms of their safe-haven stature, just because of the underlying economies. Even if the United States were to shrink in a relative sense compared with some of these countries, it is still so much bigger across the board from every metric that the liabilities of the government that are attached to that economy are still the safest instrument.