Bonds Misbehavin’

Bonds Misbehavin’


As I send these quarterly investment newsletters for publication, in the back of my mind I am always waiting to be accused of liking stocks more than bonds. After all, the content of my quarterly musings is significantly more focused on the former than on the latter. It has less to do with my personal affinity for any asset class and more to do with the disparity in the availability of news between stocks and bonds. After all, stocks tend to move, shift, surge, and correct with some degree of regularity. Bonds tend to be rather sedentary. Under normal conditions, it is tough to squeeze out 800-plus words about bonds on a regular basis as this quarter’s news tends to resemble last quarter’s. Fortunately for financial writers but unfortunately for investors, the second quarter was anything but normal and dull for bonds.

Interest Rates on the Rise
Since May 2, the 10-year Treasury yield, which is the benchmark yield for the bond market, has risen from 1.63% to 2.50%, hitting a high of 2.59% on June 25. Because bond prices move inversely to interest rates, this quick uptick in rates has proven troublesome for bond investors over the past couple of months. Between May and June, the Vanguard Total Bond Market Index Fund dropped -3.33%, a figure comparable to the -3.60% the fund lost in September and October of 2008. That two-month period was in the middle of the credit crisis to put things in perspective.

Needless to say many bond investors are a bit unnerved by these recent losses. According to TrimTabs Investment Research, investors pulled $80 billion out of bond mutual funds and ETFs in June, which is a record and nearly twice the amount pulled out by investors during the aforementioned credit crisis in October 2008. Are these bond investors right in heading for the exits? Is this the beginning of the much-anticipated turn in the interest rate cycle that will lead to the next bear market for bonds?

Investors Incorrectly Interpret Fed Language
Interest rates have risen lately largely due to concerns that the Federal Reserve will pare back its $85 billion per month bond purchase program sooner than expected, perhaps even later this year. The Fed has alluded to this “taper”, as it has come to be known, numerous times in the past few months. Their point was that they could start to taper their purchases by the end of 2013 if the economy improved to a point where it was no longer necessary.

Essentially, the Fed stated the obvious. If the economy strengthens noticeably in the coming months, they will do less to stimulate it by cutting back (or possibly ceasing) their $85 billion in monthly bond purchases. On the flip side, they also noted that they could increase the rate or amount of purchases if the economy weakens to stimulate it more. In selling in droves the past two months, bond investors only heard the first part and then substituted “would” for “could.”

Investors Incorrectly Interpret Fed Policy
Even if we assume that the economy improves sufficiently in the coming months to warrant an end of the Fed’s bond purchase program, it does not mean that interest rates are set to rise. The Fed’s zero-interest-rate policy will remain in place as they have tied that to a stated goal of 6.5% unemployment. Rather, it simply means that the additional stimulus of $85 billion per month in bond purchases will end. In selling in droves the past two months, bond investors mistakenly assumed that the Fed’s bond-purchase program and their policy stance were one and the same.

For the Fed to shift their policy stance from accommodative to restrictive by lifting short-term interest rates from the zero percent range, the unemployment rate—currently at 7.6%—will have to fall to 6.5%. Given the structural issues in the job market (as outlined here) that are preventing the unemployment rate from falling further, it will likely be years before we see the Fed change their policy stance by increasing rates.

Strategy & Outlook
Our current bond allocation is based on our projection of the 10-year Treasury yield ranging between 1.5% and 2.5%. Despite the sharp rise in rates since early May, it is still within that range. The 10-year yield appears to be leveling off at 2.5%, and we expect that projected ceiling to hold. If it started to creep towards 3%, we believe the Fed would likely intervene with either reassuring language or further bond buying to create a downward reversal in interest rates. Allowing rates to rise to higher levels is not part of their current plan to stimulate the economy via low interest rates in an effort to bring the unemployment rate down to their stated goal of 6.5%. As a result, we are not altering our bond allocation at this time as we expect rates to come back down and the recent losses in bonds to be temporary and recoverable. In other words, expect bonds to go back to being uninteresting.

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