So much for bonds being a lousy play in 2014. Investors in TLT have seen better than 20% total return this year, as Treasury rates have fallen to their lowest levels in about 18 months.
TLT – 1 Year
The bond market’s latest buying spree comes on the heels of a sharp near-term sell off in stocks. As we discussed last week, bonds, especially Treasuries are viewed as a flight to quality when stock prices drop or otherwise become volatile. The many calls for a 3.5-4% 10-Year by the end of the year at this point appear well off the mark.
While bonds can be viewed as a conservative way to generate income, this latest somewhat hyperbolic movement showcases the profit potential, and, speaking pessimistically, the dangers of attempting to time longer-term bonds. If you look at the following chart, you can see how volatile TLT has been over the past four years.
The longer-term investor who bought TLT during the summer of 2010, between coupon payments and price appreciation, has done quite well. It has been somewhat of a bumpy ride however. As we continue to sail through uncharted economic waters, I would expect rate and long-term bond volatility to remain.
Though bond bears have been arguing for many years now that the economy is on the mend, which they say should lead to a tightening rate environment, they have severely overestimated the strength of underlying fundamentals. Bond bears also seem to have assumed a statistical or probabilities based approach that has concluded that because rates have been in a downtrend for better than 30 years now, that a reversal must soon be upon us.
Any seasoned market watcher knows that rates, whether of the short- or longer-term variety, are generally dictated by economic realities. Making a bet or prediction that rates will go higher just because they’ve been low for too long is foolhardy. I like to include the following chart in discussions every once in a while – Japan’s 10-Year Government Paper – which has been sub 2% for basically 17 years now.
My personal sense is that we’re in the middle innings of a protracted period of low rates, but I still advise caution with longer-term bond buying habits. Given the general look of today’s yield curve, I don’t think investors are particularly well rewarded on a yield basis by going out much further than 10 years. If I’m wrong and it’s off to the races over the near-term, long bonds will get pummeled As far as corporate credit quality is concerned, I would keep the core of a portfolio in the BBB/BB “area,” which seems to be a relative sweet yield spot.
While we’ve seen some bearish bond moves over the past several years, the general slope of rates continues lower. Though my sense is that the U.S. bond market is not destined to become another Japan, the low rate environment may persist longer than most seem to suspect. Still, I think bond investors should continue to play it somewhat close to the vest and keep the majority of a portfolio in short-to-intermediate duration paper.
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.