It seems like all eyes are on stocks as they defy the expectations of the crowd, which has been selling stocks for 5 years now to buy bonds, and make multi-year highs, but the real story may be that the 32-year bull market in bonds is coming to an end.
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It's no secret how low rates are today, but there's nothing like a 32-year perspective to really illustrate the extremity. In the chart above, we see that the 30-year Treasury (in blue) and the 10-Year Treasury (in red) are down substantially from where they traded at what used to be perceived as quite low in the previous decade. In fact, the 10-year Treasury trades below the spike-low of 2.1% at the depths of the financial crisis.
While I have been expecting a nasty rout in bonds and have certainly positioned my Conservative Growth/Balanced Model Portfolio to minimize exposure, I have been careful not to sound the alarm too publicly, until now. With QE3 coming soon, perhaps today, we may see a "sell the news reaction" to the creation of yet more artificial demand for bonds. In any event, Treasury bonds are a poor investment, and that has implications for other fixed-income investments as well as other asset classes.
Mutual fund data suggests that the public loves bonds even more than it hates stocks, with weekly flows continuing to illustrate this point. Even if a typical IRA or 401K investor somehow managed to not sell his or her stocks after they plunged, it's likely that they have altered their contributions in recent years such that they now have more bonds than is appropriate.
It's one thing not to own stocks when they are rallying, as that's just an opportunity cost, but it's another to hold bonds when they fall. There has been little reason to be concerned with bond holdings in recent years, and there is likely tremendous complacency. The best way to look at the overall bond market is the diversified Barclays Aggregate Bond Index. Here is a chart of the iShares ETF (AGG)
Since a crazy week in late 2008 - I actually wrote about the incredible opportunity that AGG became and added some to my model when it somehow traded below NAV, AGG has done nothing but let its owners sleep well at night as it has grown in price by 12% over the past 3 1/2 years.
Before I discuss why bonds have become overvalued and why that could change, let's talk about price risk. For those not familiar with the concept of "duration," this is probably a great time to learn about this risk definition. The bigger the number, the more the price risk. Here is how it is defined on Wikipedia:
Modified duration is a price sensitivity measure, defined as the percentage derivative of price with respect to yield...
Click the link for a very technical discussion, but I will summarize by saying that the lower the coupon and the longer the maturity, the more price risk.
If you own the 30-year Treasury bond (2.75% due 8/15/42), which trades at a price of about 96.75 (2.75 yield), a 100 bps rise (1% rise) in yield to 3.75 would move the price to below 80. That's an 18% hit.
Similarly, a hypothetical 30-year bond priced at 100 (PAR) with a 4% coupon, assuming it moved to 5% (it might not rise quite as much as Treasury rates), would decline by more than 15%.
A 10-year corporate bond yielding 2.5% would lose over 9%. That's almost four years of income. AGG would lose approximately 5% of its value.
So, why am I bearish on bonds? As I will explain in more detail, the major issues are that they are expensive and the trends that have supported overvaluation are likely reversing.
Just because bond yields are low doesn't mean that they are expensive, though it obviously creates an asymmetry in terms of price risk the closer they are to zero, which is the theoretical low (not in practice, as we have observed in certain situations). Bonds tend to track nominal GDP over long periods of time. This chart is a bit outdated - it appeared on the blog of Dr. Ed Yardeni 18 months ago:
Nominal GDP, which is real GDP plus inflation, is growing at about 3%. Some may not realize it, but it is at an all-time high, well above the prior peak set in 2007. Historically, when nominal GDP growth was this low, the 10-year Treasury would still yield more than the GDP growth rate. Another way to look at it is the 10-year TIPS (Treasury Inflation-Protection Securities), which offer a negative return over inflation (you get inflation less 0.66% currently).
Bonds have benefited from substantial and continual buying via mutual funds. Sadly, people like to buy what's working, until it doesn't. The dotcom boom and bust surely illustrated this point. Professional investors have used them to hedge "tail risk," as, besides gold, they are one of the few asset classes that can work in "risk off" trades (though gold is quickly moving to risk-on status). Finally, the risk of owning bonds has been reduced by massive government support.
Now, as I explained when I discussed how I expect an Obama reelection to impact investments, we could see the inflation/deflation pendulum swing towards inflation (or at least the fear of inflation). Additionally, with so much fear of the euro weakening (or disappearing), there has been an aversion to all but German bonds. To the extent this is correcting now (and it's not clear yet how sustainable this new trend may be), U.S. bonds suddenly don't look attractive as the dollar weakens. The same might be said for German bonds except without the currency kicker.
So, bonds are expensive and the reasons they have become expensive may be dissipating. Obviously, one can take steps to avoid capital loss, by selling bonds and moving to cash. Other techniques would be to shorten maturities or move into securities with higher yields that might offset some of the capital loss.
How might rising interest rates impact other sectors? Before I share my thoughts, allow me to say that there are two ways rates rise, and I am addressing just one. The way I expect that they rise is that the economy is stable or slightly improving, and the tail-risk premium comes out. The other way is what can be simply termed a "Chinese boycott," which could be that or something similar. Essentially, if no one wants to buy our debt (which is owned in large part by foreigners, who continue to buy when we roll it over at new auctions), then it would be game over. In that scenario, I suppose guns and canned food would merit consideration.
Before I go on, let me say that rates are so low that they would have to rise a lot most likely before they did a lot of damage. I say this because rising rates are typically viewed as a negative for consumer durables, like housing or autos. If rates were to rise 1%, I think that the impact would be minimal, though the stocks might react negatively anyway.
So, what might actually be impacted more significantly? One of the first things that comes to mind are the mortgage REITs. I have written about the risks in the past. These leveraged bond funds perform well most of the time and terribly some of the time. Never pay too much above the NAV, but even when they are trading at the NAV they can decline. Sharply rising rates typically aren't good for these securities.
Other income-producing stocks could be at risk, but many likely won't. MLPs that grow their distributions will keep growing their distributions, though perhaps a bit less due to higher borrowing costs. Utilities (XLU), on the other hand, have very limited ability to pass through higher borrowing costs. REITs (IYR) stand perhaps the best chance in the scenario I describe, as rents will likely rise with a modest pickup in inflation. Still, all of these bond alternatives stand to look less attractive as rates rise.
Companies that pay dividends but have little debt and low payout ratios (i.e. not REITs, MLPs or utilities) can probably boost their dividend enough to offset a good part of the rise in rates. It helps that the spread between dividend yields and bond yields is quite favorable towards stocks.
Sectors that could fare well in a reflationary environment would include energy and materials stocks. Gold (GLD) and precious metals, like silver (SLV), are lifting again and would likely benefit as well. I like the gold miners, and there is an ETF by Market Vectors (GDX) that has really lagged the underlying metal. It's interesting that Newmont Mining (NEM), a major component, has linked its dividend to the price of gold. I have a significant exposure to GDX in my Sector Selector ETF model.
Finally, I think that a rise in rates could be fantastic for financials (XLF). It's not likely that short-rates will increase as quickly as longer rates. This higher spread should boost the net interest margin. There are a lot of reasons, many of them contrarian/sentiment, to like the sector as well.
It is always hard to call the top of a bull market, but I am willing to attempt to do so here. I am often early, which may be the case again, but the opportunity cost of holding cash instead of bonds just isn't that great, especially for Treasuries. AGG yields about 2%. If rates sit here for 5 years, your wealth will be about 10% less than it could have been (the portion in cash instead of bonds). Not the end of the world. In one year, you risk that 2% (and theoretically some potential capital gains), but, if rates rise 1% (quickly), you will lose 5%.