Yes, Bond Yields Are Going Lower; No, You Shouldn't Buy Bonds

by: Charles Lewis Sizemore, CFA

“The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates.”

—Federal Reserve Press Release, April 30, 2014

I have advice for bond bears: Listen to Fed Chair Janet Yellen. When she tells us that she expects long-term bond yields to remain low, she means it. Yes, she’s tapering. But she’s also made it clear that she considers low yields essential to a sustainable economic recovery. I wouldn’t advise betting against her; she has a bigger wallet than you.

The Fed tapered its bond program by an additional $10 billion last month to $45 billion, yet a funny thing happened. Rather than rise, the Treasury yield actually fell. The 10-year Treasury yield dropped from 2.69% the day before the Fed’s release to as low as 2.57% in intraday trading on May 5.

Remember, the 10-year Treasury started the year with a yield over 3.0%. Falling bond yields mean rising bond prices, and this has translated to impressive year-to-date returns for popular bond ETFs. The iShares 7-10 Year Treasury ETF (NYSEARCA:IEF) and iShares 20+ Year Treasury ETF (NYSEARCA:TLT) are up 3.63% and 9.89% in price terms, respectively, and that does not include returns from bond interest. To put that in perspective, the SPDR S&P 500 (NYSEARCA:SPY) is up only 2.41% year to date.

What gives?

Actually, it’s a host of issues. In the immediate term, GDP growth appears to be faltering, and the employment picture is a mixed bag at best. The economy created 288,000 jobs in April, which was better than expected, yet 806,000 Americans dropped out of the workforce. Core inflation has also consistently remained below the Fed’s target of 2% for nearly two years now.

Longer term, the retirement of the Baby Boomers has created massive demand for investment income, which has kept a lid on bond yields. And the growth rate in the supply of new Treasuries continues to slow as the budget deficit shrinks. And overseas, we see much the same story. Yields in the eurozone have fallen to pre-crisis levels and, in the case of Spain, to levels literally not seen in two centuries.

All of this is to say that, taper or not, Treasury yields are likely to remain low for a long, long time.

So, is this the trade for the rest of the year? Buy TLT and IEF and sell SPY?

Absolutely not. Bond prices may not be crashing any time soon, but that is a long way from saying that bonds are an attractive investment. While I take the contrary view that Treasury yields will not materially rise in 2014, investors looking for income can do better than the 2.59% and 3.38% currently offered by the 10-year Treasury and 30-year Treasury, respectively. Remember, traditional bonds offer absolutely no protection from even modest inflation. The interest payments you receive today will not rise over time. And yes, while you will get your principal back in 10 or 30 years, it will be worth a lot less then in today’s dollars.

You want a better income option? Try shares of Wal-Mart (NYSE:WMT). Wal-Mart’s current dividend yield of 2.4% is a little lower than the yield on the 10-year Treasury. Yet Wal-Mart raises its dividend virtually every year, and it has more than doubled its dividend since the fourth quarter of 2008.

Incidentally, Wal-Mart announced this week that its online sales grew at a faster rate than those of (NASDAQ:AMZN) during the year ended January 31.

Another option? Try Wal-Mart’s retail rival Target (NYSE:TGT). Target sports a dividend yield of 2.8%, which is higher than the 10-year Treasury at current prices. And like Wal-Mart, Target is a serial dividend raiser, having raised its dividend every year since 1967.

Target, like Wal-Mart, has had its share of disappointments in recent years. It’s core middle and working class customers have had a harder time recovering from the Great Recession than upper-middle-class and wealthy consumers. And the credit card data breach last year was a public relations nightmare for which the company is still taking heat; just this week, Target’s CEO was forced to quit due to fallout from the incident.

I am modestly bullish on the share prices of Wal-Mart and Target. I consider both to be relatively cheap stocks in a market that is, for the most part, quite expensive by most historical precedents. But even if the share prices do nothing for the next 10 years, they are still incomparably better than bonds for an investor looking to generate retirement income. Ten years from now, I would expect the dividend payout of each to be, at a minimum, 50%-100% higher than it is today and probably significantly higher.

Bottom line? Bonds are not at immediate risk for a crash. But they are my no means attractive at current yields. Income investors would be better served with serial dividend raisers like Wal-Mart and Target.

Disclosures: Long WMT.