Rising Bond Yields Are A Dream Come True

rising bond yields

rising bond yieldsIn his June 19 press conference, Bernanke noted that the Fed was “puzzled” by the recent sharp rise in interest rates. He further mentioned the possibility that optimism about the economy may be part of the reason for rising rates. As someone who is not puzzled by the sharp rise in rates, I would like to clarify for the Fed what is going on: The Fed has distorted prices and yields across the financial markets to such an extent that any hint of stopping QE causes a swift reaction in prices. Regarding Treasuries, the initial reaction is to sell or short-sell them. It is, in a sense, similar to other periods in history when the Fed has signaled a policy shift. But because of the excessive monetary easing in recent years, the reaction is exceptional. With that said, however, I would like to point out the following from my recent article, “Misinterpreting the Fed is Creating a Buying Opportunity in Bonds”:

“The Fed won’t tighten monetary policy if there is a risk of a major stock market selloff. And there will be a risk of a major market selloff if the Fed stops QE and is believed to be considering raising short-term rates. Therefore, the Fed may temporarily stop QE, but once the stock market falls and starts a chain reaction that weakens the overall economy, the Fed will be forced to start QE once again. And it is that new round of QE as well as a weakening economy and falling stock prices from stopping the previous round of QE that would eventually bring with it declining Treasury yields.”

Higher yields are not sustainable if the cause of those higher yields is simply a reactive repricing of risk rather than improving growth expectations or realistic rising inflation expectations. While financial markets across the board have experienced Fed-distorted prices in recent years, if the Fed were to stop QE, the initial reaction of a widespread repricing of financial assets would eventually give way to money flowing from the bottom of the capital structure to the top. In the U.S. economy, the top of the capital structure is U.S. Treasuries, and in the world of corporate bonds, the top is senior debt. If the reason for rising benchmark rates were a strengthening economy, then higher rates would be quite sustainable. But I simply don’t buy the argument that those traders and investors selling bonds are doing so because they believe the underlying strength of the U.S. economy has improved enough for the economy to withstand no more QE.

For quite some time, I’ve worried that the U.S. bond market would be mired in a Japanese-like experience of persistently low historic rates. Therefore, the recent rise (and I hope continued rise) in benchmark yields is a dream come true. It allows individual bond investors to look beyond the noise of fears about QE tapering and start to gradually buy longer-term single-A- and triple-B rated bonds in the 5% to 7% range. If you prefer intermediate-term bonds, many acceptable credit risks with 4% to 5% yields can be purchased.

I would like to share with readers one way in which the Fed’s ultra-easy monetary policy has changed my behavior forever. Prior to 2008, I used to believe parking money in an interest-bearing checking account, a savings account, or shorter-term fixed-income instruments would continually provide what I view as acceptable income over a long period of time. I recognized there would be times of slightly higher income (say 5% or more) and times of slightly lower income (say as low as 2%). But I thought that over a multi-decade time horizon, the average rate on the money I had no intention of spending or investing in stocks would be somewhere in the 4% range. The Fed’s extended zero-interest-rate policy has changed my view. When the Fed took rates to zero, I quickly realized the opportunity cost of letting the return on my money be dictated by the Fed was simply too great to not change my behavior. And so I changed my behavior.

I realized that if my goal was to achieve a 4% annual yield or better over a multi-decade period on my money that used to sit in bank accounts or short-term fixed-income products, then buying individual bonds would be the best way to guarantee I achieve that. More specifically, I realized that by focusing on intermediate- to longer-term individual bonds, I could also achieve a guaranteed rate far better than 4% on my money. Of course, I take on more credit risk with a corporate bond than I would with an FDIC-insured bank account, but that is a risk I was, and still am, willing to take.

The beauty of buying intermediate- to longer-term individual bonds at rates and credit risk profiles you find acceptable is multi-fold. First, you know for sure what your return will be over a given period of time, unlike with short-term bonds (rollover risk) or savings accounts that constantly bring with them the risk of changing rates. If you were hoping to achieve a certain return on your money using short-term fixed-income instruments over a period of many years, you can avoid the uncertainty of rollover risk and changing bank account rates by simply locking in reasonable rates for extended periods of time. During the recent spike in yields, I initiated a partial position in AT&T’s A3/A- rated 27-year senior unsecured notes at a yield of 5.386%. Perhaps there are some who think I am crazy to do that.

But I like to think of it as opening an AT&T savings account and being guaranteed a respectable rate for a long time. Of course, I purchased those notes as part of a very diversified individual bond portfolio, and think that anyone purchasing individual bonds should also pay close attention to the importance of diversifying across issuers. Additionally, remember that the mark-to-market moves in the prices of long-term bonds are irrelevant as long as you can hold them to maturity. Collect your coupons from businesses you trust not to default, be sure you’ve diversified enough to withstand the possibility of a few defaults, and, if rates go higher, be prepared to buy more.

Second, regardless of how the price of a bond moves over a multi-decade period, I know that absent a default, the bond will return to par. In the world of stocks, you may think your stock will one day return to a higher price. But there is no guarantee of that happening. In the world of individual bonds, if the company backing the bond doesn’t default, the price to which the bond will eventually go is guaranteed. From a planning perspective, that type of certainty is priceless.

Third, regarding inflation, when a financial professional questions your bond-buying intentions by mentioning the possibility of inflation, ask that person the rate of inflation he or she uses when putting together financial plans for clients. You will be surprised at just how low a rate of inflation financial advisors use in calculations. Moreover, it is important to understand that there may be periods of a few years over the next few decades in which inflation spikes to abnormally high rates. Those will be opportunities to buy more bonds at higher rates, raising the overall average rate of your fixed-income portfolio. In the long run, I am reasonably confident that 5% to 7% yields will prove to be a respectable starting point for bond-portfolio yields.

I understand that buying intermediate- to longer-term bonds is not an investing idea everyone will find attractive. But for those who simply want to make 5% to 7% from their fixed-income investments, that opportunity exists right now. And if rates go higher from here (let’s cross our fingers they do), you will have even better opportunities in the future.

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