Bonds: The Safety Trade Of 2019

Includes: MUB, TLH, VCHS
by: Clif Droke

Geopolitical uncertainty has made U.S. bonds a safe haven of choice.

Government bond outlook is still intermediate-term bullish.

Corporate bonds will also benefit from continued safety demand.

After being shunned for much of 2018, U.S. government and corporate bonds are making an unqualified comeback this year. With apprehension abounding over the health of the global economy, the U.S. bond market has become the haven of choice for defensive-minded investors. Several recent developments in fact support a continued bullish outlook for Treasury bonds and corporate debt. While it may seem paradoxical that corporate bonds could rally alongside T-bonds for an extended period, there is a unique set of circumstances which support this view. We'll discuss them in today's commentary.

With most stocks still not having completely recovered from last year's 20% correction, many retail investors are still aren't comfortable with being exposed to risk assets. The continued delay of Britain's exit from the euro zone has resulted in companies which do business in Britain and the EU holding off on making long-term investments. It has also encouraged individual investors to look for safer returns than the volatile equity market.

Then there is the uncertainty arising over the anticipated end to the U.S.-China trade dispute. While both sides are hopeful for a deal by the end of April, some U.S. officials worry that China is reneging on specific trade concessions. Conflicting reports on the progress of the trade talks between both nations is another reason why many are turning to the relative safety of the U.S. Treasury bond market.

One of the biggest indications that bonds are enjoying an unusual amount of popularity is when stories appear in the mainstream press about high-profile hedge fund managers making big bets on Treasuries. That was the case earlier this month when fund manager Kyle Bass, of Hayman Capital, said he expects interest rates will head back toward zero between now and next year. He further predicted that Europe and Southeast Asia would fall into an economic recession by late 2019. He believes U.S. Treasury bonds will benefit from flight-to-safety demand should his forecast come to fruition.

While there is cause for questioning Mr. Bass's recession prediction, his reasoning for being bullish on bonds is sound. My expectation is for government bonds to remain buoyant for most of 2019, with the potential for rising to higher levels by summer. I also expect to see a continued strong performance for high-grade U.S. corporate bonds, which we'll discuss here.

Let's start our overview of the U.S. Treasury bond spectrum by observing the recent progression of the iShares 10-20 Year Treasury Bond ETF (TLH), which is my favorite 10-year T-bond proxy. The following graph shows TLH in relation to one of its most widely monitored trend lines, namely the 50-day and 200-day moving averages. Both averages have a technical and psychological significance resulting from this somewhat self-fulfilling utilization.

iShares 10-20 Year Treasury Bond ETF

Source: BigCharts

One can't help wondering how much longer the longer-term Treasury bond ETF can remain overextended from its 200-day MA without pulling back. Historically, whenever TLH rises by about $5 or more above its 200-day trend line, a sharp pullback has typically followed. And if not a pullback, then an extended sideways trend which allows the 200-day MA time to catch up with the price line normally follows. As can be seen in above graph, TLH is approximately $4 above the 200-day MA right now, so there is some leeway for an additional upside move in the ETF before it becomes vulnerable to a bear raid. However, there's no denying that TLH is becoming overextended from its dominant longer-term trend line, so this will likely put a limitation on its upside potential for a while. Once the gap between the TLH price and its underlying 200-day moving average has been reduced, the longer-term bond ETF will be in a much better position technically to commence another rally leg.

The most important take away from the TLH chart is that Treasury bond prices across the maturity spectrum have risen dramatically since bottoming last November, and that rally has been largely a function of widespread uncertainties. Fears ranging from Brexit to the U.S.-China trade war to a U.S. corporate profit slowdown have wracked investors' nerves in recent months. That has naturally increased the safe haven demand of government bonds, which investors flock to in times of turmoil. There's no reason to think that these fears will dissipate anytime soon, thus the safety bid for Treasuries will likely be present for many months to come.

Treasuries aren't the only bonds which have a promising intermediate-term outlook, however. U.S. high-grade corporate debt is still reflects an unusual degree of strength and optimism in the corporate profit outlook, in spite of Wall Street's mounting fears of an earnings recession. Shown below is the Vanguard Short-Term Corporate Bond ETF (OTCPK:VCHS), which is one of the strongest performing bond-related ETFs right now. As I've emphasized in recent bond market commentaries, the recent performance in VCSH is an encouraging sign for the U.S. financial market in the coming months.

Vanguard Short-Term Corporate Bond ETF

Source: BigCharts

Investors' preference for high-quality corporate debt is undeniable right now, and there's good reason for it. Even though fear abounds over a global economic slowdown, the U.S. corporate sector is still profitable enough to attract the interest of the world's investors. High-quality corporate debt is thus viewed as a desirable form of protection from the vagaries of overseas volatility. What's more, rising corporate bond prices are a major leading indicator of the stock market's health, and I view the recent performance of VCHS to be a continued "buy" signal for U.S. equities as well as a validation that the corporate debt market remains bullish.

Even U.S. municipal bonds continue to outperform as interest rate-related pressures have dropped drastically in recent months. With the Federal Reserve providing investors with the assurance that it will hold off on raising the fed funds rate in the coming months, bond investors have turned their attention once again to the muni-bond market. Below is a graph which illustrates the performance of the iShares National Muni-Bond ETF (MUB) and provides a good overview of the national muni-bond market. You can see here the upward drift in muni-bond prices, the momentum of which suggests a benign intermediate-term (3-9 month) U.S. economic outlook.

iShares National Muni-Bond ETF

Source: BigCharts

All things considered, the U.S. corporate and government bond markets remains ideal safe havens in a world plagued with geopolitical uncertainty. Instead of reacting emotionally to recent overseas news and developments, participants should instead focus their attention on the promising outlook for U.S. stocks and corporate bonds in the coming months. As long as the Fed remains true to its word to listen to the market and hold off on raising the Fed funds rate, bonds in general should continue to benefit.

On a strategic note, investors can profit from the favorable U.S. financial market climate by having some exposure to investment-grade corporate bonds, as well as the shares of fundamentally strong companies in outperforming sectors (e.g. consumer staples, financials, and techs). Investors can also maintain a conservative long position in the Vanguard Short-Term Corporate Bond ETF discussed in this report.

Disclosure: I am/we are long SPHQ, XLE, XLF. 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.

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