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This is a fascinating time for income investors because there are excellent bond fund managers who are bullish on bonds and think that interest rates are going to fall. There are others that are bearish because they believe rates are rising. Are the bulls right or are the bears correct? Keep reading for my rather surprising conclusion in the battle of the bond bulls and bears.

In this piece from The Wall Street Journal, we first hear from the bears [emphasis added]:

For more than a year, many have argued that bonds are in a bubble, or at least very expensive. Despite that, they have remained popular.

This has puzzled the bearish bond gurus. In March, Pacific Investment Management Co.’s Bill Gross, manager of the nation’s largest bond fund, decided that Treasurys had gotten too pricey. He made a noisy exit from the market, proclaiming that the government’s horrible balance sheet and inflationary policies (super-low interest rates, fiscal largess, Federal Reserve bond purchases) would lead to an eventual rout in bond prices. He would buy bonds again, but not before yields had risen.

Since Mr. Gross’s exit, bond prices have marched higher, pushing their yields, which move in the opposite direction, lower and lower.

I think this overstates Bill Gross’s bearishness a bit although he did make numerous public statements about the unattractiveness of Treasury bonds. Many other folks have discussed a ‘bubble’ in the bond market so Gross is far from alone in his concerns.

Over the long-term, I think his concerns are absolutely valid. However, other issues can come to the fore and that seems to be the case now as interest rates remain at low levels for Treasury bonds despite the factors he mentions.

Here are recent Treasury yields: 2-Year Treasuries have a yield of 0.50%, 5-Year Treasuries are at 1.75%, while 10-Year Treasuries yield 3.1%. Finally, 30-Year Treasuries barely crack the 4% barrier by a small margin at 4.26%.

To put these yields in a historical context, let’s look at a long-term interest rate chart, which shows that interest rates moved up steadily from the mid-1970s until 1981. The big spike began in 1979 when Paul Volcker became head of the Federal Reserve. He was tasked with the mandate of defeating inflation. He aggressively moved to raise interest rates and slow down the economy.

As a result, investors in long-term bonds got crushed as bond prices fell precipitously. That was not viewed back then as a bubble, but rather as a bear market for bonds. After rates peaked in late 1981, we began a 30-year decline in rates.

click to enlarge images

Source: Investech Research

The Wall Street Journal continues:

…Mr. Gross and others argue that when the Fed stops buying, bonds will retreat sharply and yields will rise. That is because the fragile fiscal situation will prompt investors to demand higher yields to buy government debt.

A growing number of bond aces are starting to argue the other way. Being a bond bull in the current environment requires some dark thinking. Bond yields, by historic measures, are very low. For those yields to drop even further, a little economic mayhem is required. This can take several forms, but the end product usually includes recession, deflation and, in some cases, soup lines and shantytowns.

…Jeffrey Gundlach, CEO of DoubleLine, a Los Angeles investment firm that loves bonds, says the economy will become weak enough later this year for the Fed to launch a third bond-buying program.

Jeffrey Gundlach’s point is a bit obscured in this quote. He clearly believes the economy is not very strong. However, his broader point is that intervention by the Federal Reserve (QE l and QE ll) has kept interest rates artificially high.

Gundlach, by the way, manages the DoubleLine Total Return Fund (DBLTX) and he also has an excellent record managing bond funds. Formerly, he managed the TCW Total Return Fund (TGLMX).

In a presentation made earlier this year, Gundlach made the point that he believes QE I and QE II actually contributed to higher rates on 10-Year Treasury Bonds. This chart spells out that relationship:

Source: Clusterstock /DoubleLine

In this chart, the blue line represents the yield on 10-Year U.S. Treasury Bonds. In November of 2008, during the height of the financial panic, the 10-year yield dropped almost to 2%. QE I purchases began shortly thereafter and yields moved up to almost 4%. When QE I ended on March 31, 2010, yields again slumped to about 2.5%. QE II came along in November 2010 and yields again soared. QE II is slated to end on June 30, 2011. What happens then?

If Gundlach is correct and we see falling rates on 10-year and longer-term Treasuries when QE II ends, then can QE III and QE IV be far off? And, if Gross is correct, we are likely to see higher interest rates at some point in the future. It’s hard to argue with either portfolio manager’s track record so you could always bet on both the bear and the bull.

Disclosure: Kurt Brouwer owns DoubleLine Total Return Fund (DBLTX) and Pimco Total Return Fund (PTTRX)

Source: The Battle Between Bond Bulls and Bears: Best to Bet on Both