Every week people ask us good questions that spark healthy debate. Keep them coming.
The question of the week this time around was, “Is the Bull Market in Bonds Over?”.
Over the last few weeks, the 10 year U.S. Treasury Bond has gone from approximately 1.80% to 2.25%. This is a large move in a short time. It caused the Treasury market to experience the worst losing streak since 2006.
Why is this move to rates that are still only 2.25% a concern? The answer is that some feel this might be the start of a larger more consistent move higher.
Before we go much further, keep in mind that a period of consistently rising interest rates is a scenario that very few active investors (professionals included) have ever experienced. As the chart below shows, unless you started your investing career in the 1970s, you have lived in a steadily declining interest rate environment.
If we are entering a long-term period of rising rates, it will have large implications across many asset classes and the economy as a whole. Rates for borrowing will increase. Higher rates will impact the consumer and the cost of capital for businesses, which will in turn be a drag on profits. We could spend quite a few Blogs on this, but for now we will focus primarily on the question at hand, the bond market.
Keep in mind that when rates go up, bond prices go down. Most individuals that we know have intermediate bond portfolios with interest rate sensitivity factors (in the industry we use the term duration) of approximately 5% (the Barclays Agg index duration is currently 5%). This means that for every 1% movement in bond rates, the value of a portfolio is likely to move in the opposite direction by 5%. As an example, if rates go up 1%, the value of a bond portfolio with a 5% duration will drop on a mark to market basis by approximately 5%.
Looking back at the chart above, rates have been moving one way since the early 80s. This means that over the past 30 years, investors have never seen a multi-year trend of negative returns in bonds. With rates going down, bond investors have grown accustomed to seeing statements reflecting positive returns and relative stability.
If rates start to rise, they have the ability not only to change total portfolio returns but also investor behavior and attitudes toward Fixed Income. Values of Fixed Income might no longer seem fixed and, even taking into account the income bonds produce, values might decline. Based on 30 years of experience, this might come as a shock to many.
Before we move into Behavioral Finance and how this all might affect investors’ actions, let’s look at where we are today and try to answer the Big Question.
As background on the current bond market, despite record deficits and last year’s downgrade of the United States, the US Treasury market has benefited from a number of tailwinds: the reserve currency status of the US dollar, lingering aversion to equities (flows into equities have been moderate at best), slow growth, and a private sector deleveraging.
Even when you take all this into account, however, Treasury yields appear too low. Last year, the yield on the 10-year Treasury fell below Core Inflation for the first time since 1980. By almost every measure, real rates are now negative. To put this in perspective, over the past 50 years, Treasury yields have typically been 2.5-3.0% above inflation and this is all happening when we have had record U.S. debt and a credit downgrade.
Low yields have been due to a flight to quality in the Treasuries versus other government debt (thank you Europe – I guess), and slow growth, which has kept the demand for capital relatively low. Weak or slow growth explains why real yields should be very low but not, however, why they should be negative.
So, as an initial answer to the Big Question, in our opinion, rates on the 10 year Treasury should probably be 1-1.5% higher.
If rates were to move up by this much it certainly would feel like the end of the Bull Market in bonds. Investors would get statements that show the value of bonds decreasing by 5-7.5%, which might cause selling in bonds and send rates even higher.
SJM is encouraging investors to be prepared for this. It could happen relatively quickly and could be a shock (remember most have never seen values drop like this in bonds). If it does happen, however, keep in mind that it will be because markets are feeling that the growth we have been seeing in some areas of the U.S. economy is sustainable. This will be good news for other asset classes such as equities.
We think the real question is what happens once we get 1-1.5% higher on the 10 year Treasury. Will it continue to move higher?
Can the U.S. continue to show solid growth when Europe is almost certainly in wide recession, and some other countries such as China seem to be slowing? We hope so, but do not think we are going to be entering a period of high growth given this backdrop anytime soon (more on this later).
At the end of the day, the markets will decide rates. Will private investors and public institiutions (governments, pension funds, etc.) be net sellers (prices go down and rates go up) or will they be net buyers (prices stay the same or go up and rates stay the same or even go down)?
This past week, a report came out by some well respected researchers at Blackrock / iShares showing that over the past 14 months the dominant buyers of longer-dated US Treasuries have not been private investors, but pubic institutions. The iShares research states that since 2011, the Federal Reserve and the foreign public sector purchased Treasuries with maturities of at least 5 years in an amount that was greater than the total supply issued during the same timeframe. More demand than supply = higher prices and lower yields.
In our minds, the answer to the Big Question is another question. Will public institutions continue to be large buyers of U.S. Treasuries?
Current rates offer poor returns for investors but the market, after probably some period of adjustment (the up 1-1.5% in rates), can remain high (high equals low rates) for a prolonged period if the Fed continues to be accommodative and other governments and public funds that have mandates to buy sovereign debt continue to view the U.S. as the best place to park money on a relative basis.
Assuming the US economy continues to stabilize or improve, and there is no new Fed buying program, we expect the 10 year Treasury bonds to move up to a range of 3.0-3.5 sometime this year or early next.
After that, however, it is too early to tell whether large public funds (China, pension funds, etc.) will change behavior and tilt the market as a whole to a net selling position, which would probably cause a Bear Market in bonds.
So, what to do?
If you have not reset your expectations yet on what the Fixed Income portion of your portfolio will return in the future, please do.
Nothing is certain, but our money is strongly on the bet that returns in bonds will be flat to maybe slightly negative over the next few years. This does not mean that investors should move wholesale out of bonds. It just means that return assumptions and allocation tilts should be reviewed to make sure you continue to meet your goals.
As an action item, you might consider reviewing your current bond portfolio and work with your advisors or managers to make sure you are comfortable with your current interest rate exposure. Ask what your average duration (interest rate sensitivity factor) is and if it should be lower.
Next, start looking at areas to add more diversification to your portfolio. Should you look at different ways to invest in different capital structures and explore more thoroughly convertible bonds, floating rate bank loans, master limited partnerships, etc.?
Some might suggest Investment Grade bonds or Municipals might offer protection or be attractive. As long as they are high quality this, however, is currently not the case. Spreads or the difference between high quality bonds and US Treasuries are at or near all time lows. If the yields are very close between bonds then they offer no spread or rate protection to interest rate risk. It is true that High Yield corporate or municipal bonds might be attractive relative to high grade bonds, but always remember that a bond is a bond. If rates move up, all bonds will be affected.
Finally, should you consider tactical allocation shifts from bonds to equities? This is a harder call at this point. Last Fall, it would clearly have been a home run. Now with equities up double digits YTD in 2012 and talk of slower growth in some emerging markets and recession in Europe, are corporate profits and returns going to be lower?
Before we start a debate on the current attractiveness of equities, consider taking a look at the following links to pieces put out this week by GMO and Richard Bernstein:
We tend to agree with Bernstein. Continue to stay positive on Equities but focus more than some on portfolio strategies that target high quality U.S. stocks. We also continue to favor higher income equities even though we are aware that they have lagged some other types of stocks YTD.
We hope this all helps and keeps the good questions coming.
Have a wonderful start to the week!