Saturday, March 31, 2012

Is the Multi-year Bond Rally Over?

Back a month ago, I needed to rebalance my portfolio by selling some equities. I’ve dithered around reinvesting those proceeds in the fixed income portion of my portfolio, but when a CD matured this month, I simply had too much money sitting in a money market fund earning a walloping .03% a year. (That’s $30 per $100,000.)

Thinking about fixed income forced me to ask this question: is the multi-year bond rally over? My conclusion is that it is, but I have no clue how long rates will continue to stay at their current low levels. As I am writing this, 1-year treasuries have a yield of about .18%; 10-year treasuries yield 2.21%. For TIPs the real rates of return are -.11% for 10-year bonds and only .89% for 30-year TIPs.

Think about that for a second. If you buy 10-year TIPs you pretty much guarantee that after ten years you can buy less with the results of your investment than you can buy right now, and that’s before you pay taxes on your “gains.” Such a deal!

The Federal Reserve has committed to keeping short-term rates close to zero through 2014 in order to stimulate economic growth. They have also worked to flatten out the yield curve, which is part of the reason 30-year TIPs have real rates of return under 1%. (And 30-year mortgages are again under 4.00%)

Another reason for the current low interest rates is that with the instability of global economics, the US economy still looks like a good bet to those worried about their money. Despite the massive budget deficits the US runs, whenever there is a spike in economic uncertainty, money continues to plow into US treasuries.

Short-term we can have more uncertainty. The Fed can institute QE3 (quantitative easing round 3) and interest rates will again decline. Or Congress can do something stupid (alright, even more stupid than what they have been doing) and cause confidence in the dollar to drop. If I could prognosticate short-term bond moves, I’d be raking in 8 figures a year—and I’m not.

But looking at the long-term I think we must be very near to the end of the multi-year bond rally.

1. Very short-term rates cannot go much lower on a long-term basis than the virtual zero currently in effect. Yes, if there is a scare people may be willing to accept negative short-term nominal rates, but not for long.

2. Although we know bond buyers are willing to buy “safety” at the price of real value retention (witness the 10-year real TIP yield of -.11%), even as the Fed tries to flatten the yield curve, how much more real return are investors willing to give up for safety? And for how long a period—surely not for  30 years? This phenomenon cannot last forever.

3. US Inflation is running around 3% in an environment of 8% unemployment and the Fed holding down interest rates. If the Fed is successful at stimulating the economy, at some point wages will again start to rise and inflationary pressures will increase. Not only will bond yields will have to increase in order to maintain the same real rate of return, but the Fed may switch from worrying about unemployment to worrying about inflation and start to actively increase interest rates itself.

4. Money continues to move away from bonds, seeking higher returns. Corporate bonds have had a very strong run, with high-yield corporate bonds doing even better. As even these riskier investments are priced higher and higher, people will turn away from fixed-income securities and chase commodities (even more than they have.) Eventually the housing stock will rebalance and housing prices will start to rise, attracting new money.

5. Once the Fed either (a) no longer pumps money into the system because they think the employment market is healed or (b) starts to worry about inflation, their massive support of low interest rates will wane. At that point, there will be a very rapid rise in interest rates with the consequential large capital loss—largest in high-duration fixed income instruments.

I don’t know when this will happen, but I do think it will. And when it does, unless one can quickly liquidate one’s position, the capital losses will be massive. Unlike other fixed income bear markets where coupons offset much of the capital decline, now we have almost no coupon interest and so there is no cushion.

My personal conclusion is to keep in money markets only that amount I will need for expenses in the next year. Because of the Fed’s low rates, banks have little current need for investor funds so CD rates are pitiful. However, even those pitifully low rates are better than the equivalent duration treasuries, so CDs are preferable given that their principal is guaranteed (with limits) by the FDIC.

However, to even match inflation, I’ll need to put the rest of my bond allocation in short-term corporates. Doing so, I am taking on more risk, but I do not see corporate debt quality declining much in the next 24-months (and I’ll stay away from junk.) I’ll ladder a few securities, giving a bit of diversification in both company and duration. As bonds mature, I can decide how to redeploy those funds.

If I am wrong, I’ve given up a bit of yield to long-term bonds I could have purchased instead. If I’m right, I’ll save a lot in capital losses I have avoided. That sounds like a good trade-off to me.

~ Jim

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