Bond Market Bears Should Bear This In Mind

bear marketMuch to the embarrassment of countless bond market strategists, 2014 has been quite a good year for intermediate- to long-term Treasuries.  After closing 2013 above 3% on the 10-year Treasury and near 4% on the 30-year Treasury, yields have dropped roughly 40 to 55 basis points respectively.  Similarly, 2014 has been a positive experience for corporate bond investors.

  To see a list of high yielding CDs go here.  

I suppose from a strategist’s perspective, it’s safe to simply stay with the crowd and repeat the same thing over and over (“Yields are going higher”).  And because he or she doesn’t venture too far from the consensus while waiting for yields to go higher, the strategist also gets to remain employed.  But investors, who in recent years may have relied on bond-market strategists to accurately predict the future direction of interest rates, seem to once again have missed an opportunity late last year to purchase fixed-income products at attractive “real” yields (including corporate bonds and preferred stocks).

Whether you are a bond-market strategist constantly calling for higher yields or an investor who believes and/or fears that any day now rates are about to soar, here are several things to keep in mind as you shape your future bond-market perspectives.

  1. Lower rates can actually increase demand for bonds.  Investors who have certain fixed-income requirements will need to put more money into bonds than they otherwise would if rates were higher.  For example, if an investors needs X amount in total income, it takes a lot more 3% yielding bonds to obtain that dollar amount than it would if the same bonds were yielding 6%.  And no, an S&P 500 with a sub-2% yield and a P/E in the upper teens will not be a very attractive option to fixed-income-oriented investors who need income and medium-term safety of principal.
  2. As a recent Bloomberg article noted, “In a world awash with U.S. government bonds, buyers of the longest-term Treasuries are facing a potential shortage of supply.”  The article continued, “Excluding those held by the Federal Reserve, Treasuries due in 10 years or more account for just 5 percent of the $12.1 trillion market for U.S. debt.”  Given the low supply of longer-term Treasury bonds and new rules for pension funds that could triple their demand of long-term Treasuries, the bigger concern might be finding sellers, not finding buyers.
  3. Risk-taking during the post-recession years has been driven by low interest rates and not by structurally strong economic underpinnings.  Therefore, it is difficult to imagine large-scale liquidation of bonds for the following two reasons: (1) If rates rise, the impetus for the post-recession recovery goes away, and (2) if that impetus goes away, there is a decent likelihood that money begins to leave the stock market and head toward the perceived safety of bonds.
  4. It seems as if everyone hates the idea of investing in bonds.  It has been that way for several years, and, not surprisingly, benchmark Treasury yields are still nowhere near a breakout above their post-recession highs.  With strategists and many portfolio managers all on the same side of the boat, it makes me wonder who exactly will be doing enough selling to not only keep up with current Federal Reserve purchases and increasing demand from pension funds, but also to outpace the demand by enough to drive yields significantly higher.
  5. I suppose anything is possible, but given that we currently live in a world in which Spanish and Italian 10-year government debt is yielding less than 3% (recently at 2.85% and 2.90% respectively), it is hard to imagine the U.S. 10-year yield (around 2.62%) breaking out to levels higher than some of the economically-challenged European countries.  And for investors who think it’s crazy to imagine a U.S. 30-year Treasury ever going back to previous all-time lows, let me remind you that Germany’s 30-year bond is currently yielding around 2.36%.  Its 10-year is trading around 1.44%.

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