Interested In Investing In Bonds?

by: John M. Mason

Summary

With expectations that the Fed will raise its policy rate in December and then raise it again next year, some are saying it is a bad time to invest in bonds.

Yet, the US dollar and the Treasury market still remain as havens for risk-averse foreign investment monies and this flow may not yet be at an end keeping rates low.

The uncertainty relating to Fed policy and to the world economic and financial situation make it difficult to predict what will actually happen to longer-term rates in the next year.

Is this a good time to invest in bonds?

BlackRock doesn't think it is. BlackRock is the world's biggest money manager, and they "are cautious on long-term U. S. Treasuries." The reason is "the Federal Reserve's moves toward raising interest rates."

The Federal Reserve, at the close of its last meeting of the Federal Open Market Committee, indicated that it still was looking toward an increase in its policy rate of interest at the December meeting. Futures contracts suggest that this will be the case. The Fed's "forward guidance" is that rates will be increased further in 2017.

The yield on the 10-year Treasury note closed at 1.56 percent yesterday. In the first linked item cited above we read that a Bloomberg survey of economists, for what it is worth, indicates that this yield will rise to 1.72 percent by year-end and will exceed 2.00 percent in 2017.

Given such a rise in longer-term interest rates, an investment in these longer-term bonds would not be the best investment going. BlackRock, consequently, recommends that investors go into "shorter-term corporate and municipal bonds and gold" instead. But, higher rates of interest also depend upon what is happening in the rest of the economy.

During a "normal" economic recovery, economic growth picks up sufficiently to cause interest rates to rise. And, usually, most of the increase in the interest rates comes in the early years of the recovery. This has not happened in the current recovery.

As far as demand pressures building up to push interest rates up higher, the economy still remains weak and economic growth is not expected to pick up and bring growth rates above the 2.1 percent compound rate of increase, year over year, that the US economy achieved in its first seven years of the current recovery.

This economic weakness also is having an impact on inflation and inflationary expectations. Inflation is remaining well below the Fed's target rate of inflation, which is 2.00 percent. And, market participants do not see inflation moving back to this mark any time soon.

Inflationary expectations built into the yield on the 5-year Treasury note have been in the 1.4 percent to 1.5 percent range in recent months. The inflationary expectations build into the yield on the 10-year note run in the 1.5 percent to 1.6 percent range. And, these expectations have remained relatively constant throughout 2016.

Getting back to more "normal" levels of interest rates is problematic in the present economic situation. Furthermore, the International Monetary Fund has issued a warning that "the world economy is at risk of slipping into a deflationary trap and faces a historic drop in global trade…"

Furthermore, one of the major impacts on interest rates in recent years has been the flow of international funds into US financial markets due to the fears of risk-averse investors.

These flows have been so massive at times that they have taken the yields on Treasury Inflation Protected securities (TIPs) below zero during the past decade.

For example, massive inflows of money into the Treasury markets brought the yield on 5-year TIPs below zero in October of 2010 and they remained there roughly until September 2014. The yield on the 10-year TIPs dropped below zero in the fall of 2011 and remained there until June of 2013.

Risk-averse funds returned to the United States again in February and March of this year as the yield on the 5-year TIPs became negative once again at this time. The yield on the 10-year TIPs dipped modestly below zero in July 2016, but has generally remained just above zero since.

The point is that it is not just that slow economic growth is keeping interest rate yields low. And, there is no indication that the flow of risk-averse funds coming into the United States seeking a "safe haven" will reverse itself in the near future.

In fact, there are some situations in the world that cause one to think that this flow could continue indefinitely. The emerging nations have lots and lots of debt that could cause problems in the future. Some of the less-well-off, like Venezuela, are near the brink of default.

The European Union is facing many difficulties these days and faces numerous individual and joint problems that can cause investors to fear. For example, the Germans have their problems with Deutsche Bank (NYSE:DB) leading the list, although it is not the only one in Europe facing difficulties.

And, then there are the individual countries like Greece and Italy, where there is real fear that debt will, in the not too distant future, be written down. Then there are the debt loads in the rest-of-the-world. The United States has become the safe-haven of the world as the US dollar has become the world's currency.

It is not at all clear when these monies will reverse this movement in the near term and leave the United States causing the yields on TIPs to return to the 1.00 percent range. I won't go so far as to say anything about more "normal" levels for these yields which I would say would be in the 2.00 percent to 2.50 percent range.

In such a world, with so much uncertainty, it is difficult to say which way interest rates are really going to go. In that sense, longer-term governments are facing greater interest rate risk than usual.

Is this a good time to invest in bonds? The answer: It depends….

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.