In recent commentary on Marketwatch.com, Mark Hulbert speculated that the 10-year Treasury may yield 4% by Thanksgiving. His rationale centered on a positive bond sentiment spike in a proprietary newsletter index that has traditionally yielded contrarian results. In simpler terms, because so many have become positive on bonds over the near-term, we are due for a correction, i.e. a rise in rates.
Indeed, bond market sentiment has seen a swift change over the past six months. With many betting against bonds coming into 2014, the relative rally we have seen with the 10-year yield dropping from 3 – 2.5%, was widely unanticipated. Further, with the taper now in full swing and Fed tightening action possibly coming closer to reality, bond bullishness might be considered surprising.
But one must remember that the 10-year sat around 1.5% just two years ago and interest rates, just like stocks, rarely move in a straight line – even during periods of conviction. While I agree with Hulbert that 2.5% may represent a near-term bottoming out of rates, my suspicion, barring some exigent event, is that rates probably won’t reach 4% by Thanksgiving.
My personal feeling is that rates will probably start meandering back to 3% as the final five months of the year play out. A 150 basis point move over the next few months would require some shockwave event in my view. Last year’s shockwave, for example, was the Fed’s announcement that it would commence with a bond buying taper. And even then it took about seven months for rates to rise 100 basis points and bump up against 3 percent.
And remember, despite the somewhat bi-polar swing we’ve seen in bonds over the past year, the asset, particularly Treasuries, is seen as a “flight to quality” during times of stock market turmoil. With stock valuations arguably on the salty side, even a mild sell off in global equity markets could prompt a further near-term bond buying binge. Still, my sense is that we’ll see 3% on the 10-year before we see 2% again.
Seeing The Forest Through The Trees
While short-term bond market gyrations are important to understand, they shouldn’t necessarily govern a bond portfolio strategy. Though I’ve personally been keeping maturities to a minimum for some time now given the threat of higher rates, the longer rates stay low, the bigger my opportunity cost may be. Of course if rates are indeed on the cusp of a secular multi-decade rise, then the tactical bond investor would be justified in keeping to the near-side of the yield curve.
Bond ladders are investors’ best defense against the unpredictable nature of interest rates. By establishing a recurrent maturity plan for a portfolio, the investor is able to consistently buy longer-term paper, yet only marginally affect the blended yield and duration of their portfolio. The more bonds one owns and more rungs one has on their ladder, the more effective this strategy can be. While ladders can take away the emotion of trying to pick the “perfect” bond all the time, investors should nonetheless be thoughtful of the current macroeconomic environment.
And even though bonds are generally thought to be “less risky” than stocks, one must be cognizant of the credit profile one keeps. While it may seem attractive to invest in higher-yielding bonds due to the current slack default environment, when the next nasty recession rears its face, junk credit may pose more capital risk than the current tame environment may indicate.
To sum up, while predicting where near-term interest rates may head is an interesting proposition for many, in the grand scheme of things it is more important for retail bond investors to focus on the quality of their holdings. Creating an all weather portfolio complete with adequate diversification as well as an appropriate credit risk and maturity blend should help one sleep well at night no matter what the forward rate environment brings.
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.