While many market watchers called an end to the 30 year bull run in bonds following the Fed’s infamous “taper call” nearly a year ago, interest rates have fallen rather substantially, surprisingly to many, since the beginning of the year. Indeed, despite the diminishing bond buying activity from Constitution Avenue, the rate on the 10-year Treasury has been edging back towards 2.5% after bumping up against 3% several months ago.
So the question investors are asking themselves today is whether the latest move is merely a near-term pause at the onset of a burgeoning bear market for bonds or just another head fake in the multi-decade bull spree.
With the Fed having stated, “The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions,” it’s very reasonable for investors to have visibility on the conclusion of the taper and ultimately a tightening of rate policy.
Of course as the months go by, assuming Fed bond buying was not a placebo, we could start to see lagging deleterious effects as stimulation is removed from the economy. And I would opine that conditions surrounding the the real estate market and middle class, while perhaps modestly improving, are hardly what one might call robust. Thus, to assume that the taper ends without a hitch or that a tightening binge is in the cards over the next 18-24 months could be somewhat of a stretch.
But if we assume a best-case domestic scenario, what are its implications for bond investors now and in the future? First we could assume that the bullish move over the past four months was indeed a head fake, representing a normal back and fill following the swift upside rate move we saw last year. Thus, for opportunistic bond investors, the recent move would be an opportunity to exit bonds for a quick profit.
Looking further down the road, if we are indeed looking at the onset of a secular 30-year bear market for fixed-income, it certainly doesn’t mean doomsday for investors utilizing bonds purely as an income source. As I’ve harped on in the past, however, it does represent opportunity cost, perhaps substantial opportunity cost, for those buying and holding bond issues with lengthy maturities.
The safest way to avoid opportunity cost risk is to keep bond duration as short as possible to meet income needs. If faced with the thought of investing in two corporate bonds – one with a 10 year maturity and 4% yield – the other with a 20 year maturity and 5% yield, don’t stretch an extra 10 years to attain an extra 100 basis points in interest. If, over the next ten years, rates rise precipitously, you might be able to replace that 10 year bond with another 10-year bond with 7% interest. Bond ladders, as we have oft times discussed, enable a rather “rate agnostic” stance, and would be another way to mitigate general risks associated with bond investment.
At the end of the day, neither you or I, nor anyone else for that matter knows where interest rates will be in the Spring of 2015, much less the Spring of 2044. The best we can do is examine current economic data, apply some logic, and build portfolios, bond or otherwise, that help to mitigate security specific and general asset risks while simultaneously help to satisfy individual investment goals.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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