The Bond Markets: No Safe Haven

The most typical response to market difficulty is to “hide out” in bonds. Indeed, in recent years, bonds have offered one of the better (sometimes only!) sources of capital gains available.  Unfortunately, bonds do not always provide the safe haven that many assume they do and simply cannot do so today. As a starting point, remember that both stocks and bonds can have sizable drawdowns, as illustrated below.

From 1990 through June, 2010, long-term interest rates declined roughly from 8% to 3%. That isn’t likely to repeat. Indeed, it cannot.  At best, rates will be generally stable (especially after the recent surge), but probably they will increase. Bond bulls seem to expect the 30-year interest rate decline they have experienced over most or all of their working lives to remain a given. It isn’t (see below).

Increasing government deficits can only increase pressure on interest rates.  According to the Congressional Budget Office, the red line in the chart below reflects the current obligations of the federal government while the blue line represents revenue. These deficits mean that the federal government will continue to need to borrow money to finance government operations. This added supply of bonds will necessarily impact demand.

Notice that these deficits are getting bigger and bigger while tax rates remain low amidst political pressure to keep them low – which emphasizes the extent of the problem.  The recent debt ceiling “solution” resulted in surprisingly little actual progress.  Moreover, the tendency of voters to demand more in the way of services while paying less in taxes is as consistent as politicians’ willingness to pander to them.  This nonsense is a problem anytime.  In difficult economic times, it is a recipe for disaster.

Foreign investment in U.S. bonds, which has offered consistent support to bond prices and low rates, may well have peaked, which could also begin to put pressure on interest rates.

 

 

In an effort to stimulate the economy, the Fed has been an enormous buyer of bonds – keeping rates low.  Recent debate (since the end of QE2) over what the Fed can and should do (QE3?) as well as continued economic weakness makes potential Fed buying going forward a significant unknown. 

 

Source: Federal Reserve

Notice, however, that the Fed has been funding most of the deficit.

If the Fed stops its active bond buying and foreign governments reduce their buying, demand will dwindle, hurting bond prices and pushing interest rates higher.

Finally, Standard & Poor’s became the first of the big three rating agencies to downgrade U.S. debt. That downgrade has not pushed rates higher, at least so far, and continued economic weakness should offer some support for bond prices (as we have seen today in response to a weak jobs report).  However, at the very least, the long-expected new era of U.S. Treasury price volatility may finally be here.  In any event, the situation is unsustainable over the longer-term, and what is unsustainable tends to stop.

Note, too, that a rising interest rate environment will have an adverse impact on other types of investments.   The following chart shows historical yields for U.S. Treasury 10-year notes.  Inflation-adjusted returns reflect the average consumer price index (CPI) of 5% (1954–1981) and 3% (1981–2010), and reinvestment of capital gains and dividends, if any. Equities are represented by the S&P 500 Index and fixed-income is represented by the Barclays Capital Aggregate Bond Index.  Obviously, rising rates will hurt equities too.

Sources: St. Louis Federal Reserve Bank; Morningstar  

Investors are not generally surprised by these facts. What they are not typically aware of is the extent of the risks in bonds. Research Affiliates calculated how much investors would lose on certain Treasuries over two years (from January 1, 2011-January 1, 2013) if yields reverted to their 50-year averages. It isn’t pretty.

The Research Puzzle had a helpful piece earlier this week amplifying the point.

Is a bond bubble on the horizon? No one can say for sure (I think so, but — like Bill Gross — I may well be wrong), and it is always dangerous to risk fighting the Fed, but I can say with certainty that the recent high bond market returns are over. The math demands it. Three years ago, five-year Treasury notes were yielding roughly 4.125%. A similar-duration bond fund should have returned this yield plus price appreciation, producing a three-year annual return of around 6.75%. Even with rising rates in the latter stages of 2010, a five-year Treasury note as of year-end still yielded around 2%.

In order for a bond fund of similar duration to generate 6.75% annually over the next three years, the yield from interest rate declines must contribute around 5% annually to the total return.  Thus rates would have to decline by about another 5% – and that simply (obviously!) cannot happen. A decline of five percentage points would translate to a substantially negative yield. On the other hand, under less favorable scenarios for bond investors, such as if rates go back up to where they were three years ago, a soundly negative return will result. If rates go up quickly, the decline in value will be even sharper.

Bonds simply cannot continue to be the safe haven so many investors expect them to be. The best that bond investors can hope for right now is relative stability.

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