My Biggest Fear As A Bond Investor

Includes: HYG, IEF, JNK, PHB, TLT
by: The Financial Lexicon

We have all heard it before: As interest rates inevitably rise, bond investors will be crushed as the price of the bonds and bond funds those investors purchased decline in value. This has been the favorite spiel of financial market pundits hoping to finally get the "wall of money" out of bonds and into stocks. Of course, over the past few years, the wall of money flowing out of fixed income and into equities never materialized. No matter how high stocks went and how low bond yields went, the trend has remained the same for quite some time: Retail investors are buying bonds.

Even the strong rally in intermediate-to-long-term benchmark Treasury yields from late July to mid August was not enough to scare investors out of bonds. In fact, not only were retail investors not selling their bonds and moving into stocks as the 10-year Treasury (NYSEARCA:IEF) and 30-year Treasury (NYSEARCA:TLT) each jumped roughly 50 basis points in just a few weeks, but those investors actually increased the pace of their bond buying during that time.

According to the Investment Company Institute's "Weekly Estimated Long-Term Mutual Fund Flows," during the first week of the rally in yields, inflows into bond mutual funds slowed just a bit from $5.763 billion in the week ending July 25, 2012 to $5.090 billion in the week ending August 1, 2012. Then, inflows rocketed higher, jumping to $7.200 billion and $7.588 billion respectively in the weeks ending August 8 and August 15. At the same time, outflows from equities continued strongly, totaling $12.562 billion during the three-week rally in bond yields.

Investors in the high-yield corporate bond market even made money during the rally in Treasury yields as spreads contracted enough to offset the rise in benchmark yields. The "BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread" narrowed 51 basis points from July 25 to August 16 as Treasury yields were rallying, and the three popular high-yield ETFs: HYG, JNK, and PHB, each rose a bit more than 1% during that time period.

The same pattern was repeated during the September rally in bond yields, as inflows into bond mutual funds topped $16 billion in the two weeks ending September 19. This occurred as Treasury yields jumped, high-yield spreads narrowed once again by more than 50 basis points, the aforementioned high-yield bond ETFs rallied, and withdrawals from equity mutual funds topped $8 billion.

Given the data I just presented, it would not surprise me if some readers are thinking to themselves that this is just another sign of a bond bubble. After all, historically, retail investors are known as the "dumb money," buying high and selling low. When combining this with the fact that the Fed has gobbled up unbelievable numbers of bonds over the past few years, the bond market surely is in the midst of a massive bubble destined to collapse. That may well be, but five reasons come to mind that worry me rates will stay historically low for an unbelievably long period of time.

First, as I discussed in my article, "The 7 Plagues Of Investor Confidence," for many different reasons, confidence in the stock market has been shattered in the retail investor community. With confidence shattered to the degree it has been, I fear it could take a very long time for many investors to reverse the current trend of pouring money into bonds. I think we will need a long break from reasons to distrust the equity market for many retail investors to feel a renewed sense of confidence in stocks. Should another brutal equity bear market occur before confidence is restored, I fear it will be lights out for the stock market for many years to come. Three brutal bear markets in less than twenty years will simply be too much for many investors to take. This is especially true for investors nearing retirement, which brings me to my second reason that yields may stay low for a very long time to come.

Experiences in life can have a profound effect on the types of people we become. Experiences will also have a profound effect on the types of investors we turn into. Just as the inflationary and interest rate experiences of the 1970s and 1980s shaped a generation in terms of their fear of inflation and rising rates, so too will multiple stock market collapses and reasons galore to distrust the stability of the financial markets shape a new generation of younger investors.

With the generation shaped by a fear of inflation and an affinity for equities nearing retirement, I suspect millions of those people will put a heavy emphasis on fixed income as they shape their portfolios for their retirement years. This will continue to put pressure on equity flows and help push flows into the bond world. At the same time, I suspect the younger generation of investors will not fall in love with equities in the way many pundits expect and in the same way their parents' generation did. These younger investors will be psychologically influenced by two brutal bear markets in nine years, a housing market collapse, the fear of losing their job or not finding a decent paying job, and the seemingly never-ending uncertainty that permeates the political, financial, and business climates. This will continue for quite some time and also be supportive of bond flows, although not necessarily a drag on equity flows.

Third, over the past decade, technology has opened the door for retail investors to gain access to unprecedented amounts (from an historical perspective) of information about investing. As investors continue to educate themselves on websites such as, I suspect they will come to recognize that some of the mantras used among equity investors are also true in the world of fixed income. Two such examples are to "buy the dip" and "dollar-cost average."

Fourth, as pension funds deal with the realization of massive future liabilities turning into a present-day reality and banks grapple with the new world of higher capital requirements, these financial institutions will provide a continuing bid under the bond market. This will occur to an extent that investors will not have seen in decades, if ever.

Fifth, through the federal funds rate, the Fed already had control of the short end of the Treasury yield curve. With its bond purchase programs, it also took control of the long end of the curve. I will be quite surprised if the Fed becomes a seller of the long end of the Treasury curve at any point over the coming years. When the entity that essentially is the market is not selling, and the entity that essentially is the market is able to print money at will to buy more, it is hard to imagine any seasonal or cyclical sell-off in bonds turning into a secular bear market.

Furthermore, as the Fed noted in the statement following its September meeting, "the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens" (emphasis added). It will likely be a very long time before the Fed raises rates. It might even be well beyond its current target of mid-2015 for maintaining "exceptionally low levels for the federal funds rate."

It is the combination of these five reasons that my biggest fear as a bond investor is that rates will not head significantly higher for many years to come. Lower rates scare me far more than rising rates. I would love the opportunity to buy on a massive dip or average into individual bond positions during a bear market. This would be no different than what I do with other assets in my portfolio.

But what about the mark-to-market losses on bonds the pundits claim will scare investors into stocks if yields ever rise? A part of anyone's portfolio management should include adequate attention toward liquidity. If your portfolio is well diversified and you have planned for your liquidity needs in a rising-rate environment, then those mark-to-market losses can be ignored. This is especially true for the individual bond investor.

On the other hand, in an environment of ultra-low interest rates, as your bonds mature, you will be confronted with the difficult decision of rolling the funds into new bonds at lower yields, thereby decreasing your income, or finding something else to do with the money. For the investor interested in maintaining a certain bond allocation in a portfolio, rolling those funds into new lower-yielding bonds will be a painful experience. Especially for investors needing to maintain certain cash flows from the bond side of the portfolio, ultra-low rates might even force an increase in the allocation to bonds just to maintain those same flows. That would be just one of many unintended consequences of the Fed's ultra-easy monetary policy.

I am well aware of the arguments routinely presented about a bond bubble and an imminent bursting thereof. I am constantly on guard for that to happen. I cannot wait for yields to go higher. While higher rates may bring with them mark-to-market declines relative to today's prices, higher rates will offer bond investors so many wonderful opportunities that it is hard to understand why one should fear such a thing.

Instead, the thing to fear is a world of never-ending historically low rates. That is a world in which savers will be forced to save more and consume less in order to realize the same level of cash flow from their investments that they once enjoyed. That is a world in which tens of millions of baby boomers will struggle to make ends meet as their insufficient savings (as a collective whole) either accept meager bond rates or venture down the capital structure into the volatile and less certain world of stocks. And that is a world in which investors, fearful that unconventional monetary policy will create inflation, create that inflation themselves by driving commodity prices higher than they otherwise would be without the tremendous demand from investment funds. For this investor, that is a much scarier world than a world that returns to historically normal levels of interest rates.

Disclosure: I am long HYG. 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.

Additional disclosure: I am also long numerous individual bonds across various parts of the fixed income market.