The Future of Our Bond Market, With Three Bond ETFs to Buy and Two to Avoid

Includes: CLY, ISHG, SHY, TIP, TLT
by: Jeffrey Dow Jones

At least for the moment, talk of The Great Bond Bubble has slipped off everybody’s radar. Does that mean it's no longer a risk? Is it time to buy these things or short 'em?

I’m not ready to climb on board with the “get short bonds” trade yet, but I do believe that this is not the time to mindlessly shift money from wherever into whatever looks most attractive in the bond space.

Junk yields are back to pre-crisis levels:

Junk yields are one of our Three Amigos and they’re a terrific economic indicator, but I think this action speaks more to investors’ desperation for yield than it does about the improvement of the economy.
The junk spread over AAAs is currently about 4%. In the 90′s or even the mid-aughts, that might have been sufficient compensation for that level of risk. But today? With all the booby traps and potholes up ahead, and with all of those “structural headwinds” that the brainy guys at Pimco are always talking about? I’m not convinced that the extra 4% is worth it. In fact, I’m pretty sure it’s not.

The rule of thumb in the bond market right now is easy to understand but requires discipline to practice: do not reach for yield! Stay near the front of the curve and favor higher quality offerings to lower. This is hard for a lot of people to hear because high-quality short-term yields are pretty miserable. They're not the kind of thing that an investor can live off of. But it beats making a crucial mistake and having to live off of nothing.

Look, we’ve had basically a 30-year bull market in bonds. It’s been a great ride. The details in the bond market today are different, but the psychology should sound eerily familiar. Remember in the late 90s when we all thought stocks would grow for 15%/year forever and ever? That stocks were the greatest long-term investment ever? Do you recall real estate circa 2005, when everybody thought that housing prices had never gone down and never could go down?

This is the psychology that’s present in the final stages of epic bull markets, the belief that the trend simply must continue indefinitely. I know that bond bears have been talking about this for years, but interest rates can only go so low and while it seems like they could definitely move lower still, the juice that’s left to be squeezed probably isn’t worth the risk of being exposed to another great unwind.

Here’s a chart of the BlackRock High Yield Bond fund. Unlike a lot of funds, this one actually made money over the last decade. The portfolio’s current yield is about 8.25%. It’s rated five stars on Morningstar. On the surface that sounds damn sexy.

I’ll admit, that’s a nice looking chart. This is probably as good as it gets in the higher yielding space. But this is a fund that has a 30% drawdown! This fund went nowhere for three whole years. Three years! Do its investors really understand what can happen to a fund like this if things get dicey in the debt markts? Do they rationalize that risk by anchoring themselves to that current yield and assuming that over the long run they’ll be just fine?

This is the kind of thing investors are chasing, something that they plan on living off of?

It’s crazy how much money retail investors have piled into bonds. $170 billion has flowed into junk bond funds in 2010, an all-time record and the year isn’t even 3/4 finished. It is charts like the one above that have been the justification for that record inflow.

Has anybody looked at a chart of (real) bond returns in the 1970s? They were terrible! I know all this stuff has done well during the last decade, but what does that have to do with performance in the decade to come? What happens if the interest rate cycle finally turns upward? I’d even make the paradoxical bet that many of these mindless bond chasers have also bought in to the inflation meme. That goes to show how little thought and planning the average investor gives to the decisions he makes. The only things that matter to him are current yields and past performance.

Here’s a chart of the 10-year Treasury, the grand-daddy interest rate benchmark of them all.

Seriously, there aren’t even that many folks still around that did much active investing during a secular cycle when interest rates were trending upward. All that most of us in this industry have ever known is an environment during which interest rates have slowly, consistently gone down. That’s awesome if you’re a bond investor — lower rates means that the value of the bonds you currently own goes up.

That being said, the 10-year has dipped below 2.5% before and it could definitely happen again. The yield on the 10-year Japanese Government Bond [JGB] is about 1% right now. This is exactly why I’m not ready to climb on board with the “get short bonds” trade yet. I think we are turning somewhat Japanese in this country and that means that there could still be some life left in bonds. A death rattle, if you will. If Japan is indeed the template for the US, then it’s far more likely that our bond market will follow theirs. Instead of rates bouncing like a tennis ball and trending back up again, I think they will instead go splat and stay there.

Here, take a look at the future of our bond market:

Anyway, we’re clearly in the later innings and the risk has increased. So be careful. Stay near the front end of the curve and stick with higher quality. Or play it tactically and wait for better entry points.

The Trade
OK, so what's the trade?

In ETF land, buy stuff like SHY (NYSEARCA:SHY) or ISHG (NASDAQ:ISHG) or TIP (NYSEARCA:TIP) if you're still worried about inflation. Avoid stuff like CLY (NYSEARCA:CLY) or TLT (NYSEARCA:TLT). I mentioned the BlackRock High Yield Bond Fund (MUTF:BHYSX) above. The time to buy a fund like that was early 2009. Today, I prefer funds with an exact opposite mandate, funds like Vanguard Short-Term Investment-Grade (MUTF:VFSTX).

It would be a great irony indeed if the average investor, having been burned by three consecutive bubbles, leaping from lily pad to lily pad chasing stocks, real estate, and credit, sinking each one in succession after discovering that every other frog in the pond had leaped to the exact same places at the exact same times, now looks around and sees that once again all the frogs have gathered on one lily pad, the bond lily pad.

I don’t believe that this one will sink in spectacular fashion the way the others have. But I do believe it’ll be a disappointing place to hang out, and in the case of junkier bonds, the returns just won’t be worth the risk.

Author's Disclosure: Long VFSTX and TIP