Remember Apple's (NASDAQ:AAPL) famous bond offering from last month? That's right, that was just last month. What may be even more shocking than Apple's timing in selling debt at the absolute bottom of the interest-rate cycle was investors' appetite for it. During the first week of May you could have locked in annual interest of 3.85% on your money for 30 years from AA+ rated Apple - as of today, a 30-Year Treasury Bond will pay you almost the same rate (3.60%). Incidentally, as of today, the U.S. government also maintains an AA+ rating from Standard & Poor's.
Those same bonds Apple sold are currently trading in the secondary market at around 87 cents on the dollar. That means you've already lost 13% on paper if you bought the new issue. At 3.85% per year, that's more than three years' worth of interest payments. Buying them today, in the secondary market at 87.00, would get you an annual yield-to-maturity of 4.60% (and a small tax gain when they mature at 100.00). Of course, that means you have to hold on for 30 years. And the chances of these bonds trading well over the next 30 years? Dubious.
We just saw what happened when rates moved sharply higher for one month. Can you imagine where these bonds will trade if rates continue to normalize - with the 10-yr Treasury at 4.50%, for example? Try the neighborhood of 60 cents on the dollar, theoretically wiping out ten years' worth of interest income. And then what? Sell for a tax loss and move on? Double down? If you like the idea of investing in depreciating assets, I assure you there are more enjoyable options.
Why is this important?
It's important because many of us have been wrong about risks and opportunities the past few years, in the wake of our world's near economic collapse.* What the Fed really did was provide you with a window to refinance your debts and prepare your portfolio, and yourself, for the end of the long-term bull market in bonds. The brisk nature of the recent sell-off in all assets was merely a reminder that the window will not stay open forever. The rally in equity markets has certainly been a nice by-product of Bernanke's inflation efforts, but perhaps it isn't/wasn't the most relevant piece of the puzzle ...
* I recognize that some people are still hoping calling for this.
Below is a chart of the long Treasury Index (NYSEARCA:TLT) since the recent stock market correction began on May 21:
"Wait - I thought he said stock market correction."
That's right, I did! And here is the same chart overlaid with the S&P500 (in green-ish):
The reason investors traditionally like bonds is because they provide a hedge against stock market volatility, especially in times of stable or plunging interest rates. The chart above demonstrates that even in a time of stock market volatility, it is possible to lose more money in bonds than in stocks.
The problem is that many investors aren't old enough to have experienced, or choose not to remember, extreme volatility in the bond market. The fear when stocks lose value on paper is that they may not come back, or may not come back as quickly as we'd like (to restore the "lost" value to our portfolios). It has been a long time since bond investors faced that dilemma; below is the 10-Year Treasury over the past 50 years:
The chart above demonstrates that the last time we had a meaningful time horizon where rates moved higher ended 30 years ago. And what did the S&P500 do from 1962 to 1983, you're asking?
And the point?
The point isn't that history will necessarily repeat itself, nor are we claiming that interest rates will continue the parabolic move higher we've seen since mid-May. But maybe we should be treating the recent move down in bonds - which, by the way, make up 40% of the standard "60/40" portfolio - as a warning shot from Ben Bernanke. A stern message that maybe you shouldn't stay so comfortable in portfolio allocations that have worked for decades. Keep in mind, also, that a debt-issuer's credit rating represents solely their ability to make interest payments and return your principal at the end of a bond's term.
So the question is this - if you now know you can experience stock market-like volatility in bonds, what are you looking to get from that portion of your portfolio? Perhaps it's our expectations that need to be adjusted from here on out. Our expectations of the market; of what level of volatility we are okay with; and of what level of volatility we might need to be okay with.
Disclosure: I am short TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.