By Michael Vodicka
Bonds are supposed to be safe investments. But what most fixed-income investors don't realize is that bonds have rarely been more risky. That's because with interest rates near record lows, bond prices are vulnerable to huge losses if interest rates rise.
And that's exactly what they've been doing.
May was the fourth-worst month in 20 years for the bond market. Fund-flow data showed aggressive selling in a broad spectrum of fixed-income markets, with the iShares Barclays 20+ Year Treasury Bond (NYSEARCA:TLT) falling 5.2%, its biggest drop since the financial crisis.
The recent wave of weakness hitting the bond market has many investors asking if this is the beginning of a longer-term trend of rising interest rates.
According to analysts at Goldman Sachs (NYSE:GS), the answer is yes. In a recent note, Goldman warned its clients on the danger of rising interest rates.
"At the 10-year maturity, U.S. government bond yields are now back at the middle of a broad 1.5% to 2.5% range in place since the summer of 2011. Our bond valuation models... indicate that 10-year Treasury yields should currently be trading in the upper half of this range (between 2.1% and 2.5%), taking into account the decline in systemic risks and the brightening U.S. economic outlook. Our model estimates (and, consistently, our forecasts) show 10-year Treasurys reaching 2.5% in the second half of this year, with German Bunds trading at 1.75%."
Goldman's bearish call on bonds is being driven by its more optimistic view on economic growth, saying that bond markets are overbought relative to underlying economic conditions and that the stronger than expected payroll report compensated for recent weakness in economic data.
But Goldman also makes note of the Federal Reserve, the 800-pound gorilla in the bond market. After four years of steadily growing quantitative easing, the Fed is talking about scaling back the size of its monthly bond purchases. And that is already having a big impact on fixed-income markets, with bond investors front-running the Fed and taking profits on the big gains that bonds have produced in the past few years with the Fed bidding prices higher.
If the Fed scales back its bond purchases, the Treasury market will struggle to replace its biggest buyer, and that will have a devastating effect on bonds and bond investors.
Interest rate movement is not thought to be fickle. Interest rates are highly directional and tend to rise and fall in multiyear patterns based upon business cycles. That means this initial turn in the bond market could be an early signal of a larger trend as investors demand more return for the risk of buying a bond when stocks look cheap and earnings are at an all-time high.
But while many investors will use Goldman's opinion as a chance to reduce exposure to weakness in the bond market, it is also an opportunity to profit from the turn.
The ProShares UltraShort 20+ Year Treasury (NYSEARCA:TBT) is an exchange-traded fund that gains in value when interest rates rise. With yields jumping in the past month, shares of this fund have been hot, up a market-beating 10%.
But this is no Johnny-come-lately ETF. With assets under management of $4 billion and average daily volume of 5.8 million shares, it ranks as one of the most popular funds in the market, able to accommodate even the biggest players on the Street. A 0.92% expense ratio is high compared with the entire ETF space but only slightly higher than a competing exchange-traded note, the iPath US Treasury Long Bond Bear ETN (NYSEARCA:DLBS).
On the tax front, although many ETFs limit potential capital gains by exchanging lower-cost bonds in their portfolios for redeemed ETF shares, this fund conducts the transaction in cash and then enters into independent swaps. That makes shareholders liable for capital gains, where the fund has been forced to make a number of sizable distributions to its shareholders.
Risks to Consider: Treasurys are still viewed as defensive, which means weakness in the equity market could fuel inflows back into bonds. Although stocks continue to trend higher, any weakness in the economy would shift capital out of stocks and back into bonds.
Goldman is warnings its clients to expect higher rates in the second half of the year as the Fed signals its desire to taper its participation in the Treasury market. As the world's biggest buyer of Treasurys, the Fed's decision will have a profound effect on the market. That poses a huge threat to bond prices, making this the perfect time for investors to review their exposure to the bond market or even profit from rising yields with the ProShares UltraShort 20+ Year Treasury ETF.