Bonds: Treasuries Up, Junk Down In Risk-Off, With Higher Rates And Lower Prices Ahead

by: Richard Shaw

JP Morgan sees the possibility of the 10-year Treasury reaching about 1.50% yield before the European debt crisis is past one way or the other, as people seek to hide from risk. They also see the rate at about 2.75% a year from now.

In addition to loss of purchasing power during the holding period, the rise in rates portends a loss of nominal principal as well if the bonds are sold, presuming no self-interested retail investor would hold a 1.5% Treasury for 10 years to maturity.

We think that Treasury money market funds at 0% yield are a better bet than 10-year Treasury bonds, because the hiding position is not for along time, and the risk of capital loss in Treasuries is not worth the net yield.

Longer-term, the 2.75% yield prediction is well below where rates will likely go. Over most of time, 10-year Treasuries have a higher yield than the rate of inflation. A visual inspection of the spread between inflation and 10-year rates suggests something like a 2.5% spread.

If the Fed target is 2% inflation, and if history suggests perhaps something more like 3%, and if the flood of liquidity that has been unleashed since 2008 is not somehow dried up, 10-year rates of 4.5% or more are a virtual certainty. Owning a 1.5% to 2.0% Treasury as rates go to 4.5% or more would be highly unattractive.

Figure 1 shows the concurrent rate of inflation since 1962 along with the average 10-year Treasury rate for the period. Figure 2, shows the spread between those two rates.

All investment grade bonds should suffer as a result of any significant rise in interest rates.

Credit bonds should go down a bit during fear-laden periods such as now with Europe.

Investment grade (NYSEARCA:LQD) should do better than below investment grade (HYG or JNK).

Shorter-term (CSJ and SJNK) should do better than longer-term.

Treasury ETFs (NYSEARCA:IEF) will rise for now, but can't stay there.

Figure 3 looks at performance of several of those ETFs in comparison to the Aggregate Bond Index ETF (NYSEARCA:BND).

Figure 1:

Figure 2:

Figure 3:

Disclosure: QVM has positions in HYG and CSJ as of the creation date of this article (May 18, 2012).

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