Bond Investors Have No Reason To Panic

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December 12, 2016 6:26am NYSE:AGG

Bonds

From David Fabian: Income investors are currently facing an uptick of concern over bond holdings that is reminiscent of the 2013 taper tantrum.


While it was no more than a few years ago, many are quick to forget the terror that resulted from a sharp rise in Treasury yields and concomitant fall in bond prices.  I can also starkly remember just how wrong 99% of economists were on predicting the future direction of interest rates in 2014 and beyond.

In hindsight, the 2013 top in the CBOE 10-Year Treasury Note Yield ($TNX) at 3.0% was the cycle high that led to a fantastic buying opportunity and another solid run for fixed-income.  Flash forward to 2016 and conditions in the bond market are reaching a similar level of anxiety.   The Treasury yield curve is steepening, inflation fears are rising, and there is a sense of concern that “this time may be different”.

Is this finally going to be the end of the decades long bull market in bonds that wreaks ruin for income investors?

There is no way to answer that question to any definite degree.  I certainly wouldn’t trust the opinion of an economist in this field.  Anyone who says they know exactly how this is going to play out is trying to underscore their own conviction or boost their overly inflated ego.  However, we can frame the context of this most recent move and look at where we may ultimately end up.

So far we have seen 10-Year Treasury Yield rise from a low of 1.35% to a recent high of 2.5%.  That’s an 80%+ rise in a span of four months.  Over that same period, the iShares Core U.S. Aggregate Bond ETF (AGG) has fallen -4% in price.  FOUR PERCENT.  Not an ideal return, but not cause for an undue level of alarm either.

Using those correlations as a base-line, we can assume that a move back to the 3% on the 10-Year (the 2013 top) will likely coincide with another 1.5%-2.0% decline in aggregate bond prices.  For the sake of a rational perspective, a -6% high to low decline isn’t all that bad.  It beats the type of volatility that stock and commodity investors have endured over the last several decades.

We can also extrapolate this data to even higher interest rates for those who want to view this asset class in a glass-half-empty manner.  A move to 4% on the 10-Year would likely result in a 10-12% total decline from the 2016 low in AGG and equivalent indexes.  A shot to 5% in Treasury yields would likely result in a fall of 16-18% from the highs in bond prices.

These are approximations based on recent price action, so don’t hold me to the fire on exact outcomes if we reach those levels. There are always going to be sectors of the bond market that do a little better or a little worse depending on prevailing conditions.

Of course, bond yields don’t move in a straight line and would likely take many months if not years to unwind in an orderly fashion.  Those who are predicting some sort of crash or bear market for fixed-income are likely just trying to generate headlines rather than save you any real money.  Crashes do happen, but they occur far more frequently than the media would have you believe, and no one can predict them in advance.

In my opinion, investors who have long been advocates of fixed-income should not abandon this asset class even under a persistent rise in yields.  There are several strategies available to reduce interest rate risk or position yourself to mitigate losses without turning your back to the entire lot.

Bonds continue to be a source of reliable income, low volatility, and a shock absorber of other high risk asset classes in the context of a diversified portfolio.   Taking a one-sided view of the bond market is a very short-sighted endeavor with a low payout over the long run.

This article is brought to you courtesy of FMD Capital.


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