"All things end in tears" is an old Irish saying. For the investors who've jammed trillions of dollars into bond funds in the past five years, tears are exactly what they're going to see at some point. Before I go any further I want to tell you that I HATE investment articles that begin with something like this, "The Coming Massacre in ________!" or Investment XYZ, what you MUST do NOW! Investment writers know they have to sell the sizzle and headlines like this are designed to get you to read what they have to say. Often it's not as jarring or important as the headline portends, but that's what sells in America today.
So let's just say that I hate having to tell you that if you own bond funds, at some point you're going to be in a world of hurt. Now I don't think that's day comes tomorrow or maybe even next year but I do know as surely as the sun rises in the east and sets in the west that bonds are headed for a large fall at some point and today I want to tell you why that is.
The US ten year Treasury Bond currently trades at a yield of about 2% which is up from around 1.6'% range a few months ago. In an article written last summer for the "Motley Fool.com" a gentleman by the name of Alex Dumortier took a look at what happened the last time interest rates were this low:
"At that end of last month, on May 29, the U.S. 10-year Treasury yield fell to 1.65%, the lowest value since March 1946. How, then, did bond investors fare the last time yields were at this level? The following table shows the after-inflation annualized return long-term government bonds produced over the five-, 10-, 20- and 30-year periods beginning in April 1946:
Investment Period
|
Real Return on U.S. Long-Term Government Bonds, Starting in April 1946
|
|---|
5 years
|
(5.8%)
|
10 years
|
(2.6%)
|
20 years
|
(1.3%)
|
30 years
|
(1.6%)
|
Source: Ibbotson Associates, a division of Morningstar; author's calculations.
These numbers are absolutely horrific. Let me remind you that these returns are annualized: Over the 10-year period spanning April 1946 through March 1956, for example, the purchasing power of one's investment suffered nearly a one-fourth decline. There is little reason to believe that long-term government bonds bought today will produce a significantly different result."
Most recently in an article titled Bond Market Bust, the New York Post's Jonathon M. Trugman took a look at what is likely to happen when bond rates start to move higher. Here's an excerpt: "{R}ates would not have to go through the roof to take out billions in principal for investors, most of whom are in bonds because they are nearing retirement.
'If the 10-year [bond] goes up 100 basis points, that could mean more than $35 billion is lost,' says one bond trader. One hundred basis points is just a 1 percent increase, which would put the 10-year at about 2.6 percent. The average rate of return over the last decade is roughly 4 percent, which, if we return to that yield, could put principal losses close to $500 billion, says a bond manager."
Bond yields peaked in the early 1980s in the double digits. When I started as a broker money market accounts yielded 8%. Now they yield nothing. But month after month investors pump money into bonds. Most of that money goes into bond mutual funds or ETF bond funds. Josh Brown in an article on this subject over at his website "The Reformed Broker" notes a recent comment from Fidelity:
"Far too many investors are waltzing around as though they're somehow 'safe' because of these massive bond allocations they're nurturing. They are walking beneath a dangling piano hoisted 10 stories above their heads, its shadow barely noticed in the noon-day sun.
Let me show you something - this comes from Fidelity and it is the statistical equivalent of buffalo herd charging across the prairie toward an unseen cliff:
The below-average real returns for equities during the past 12 years, in combination with the near- uninterrupted 30-year rally for bonds, has led to a recent shift in investor preferences. Since December 2007, investors have poured more than $1.1 trillion into bond mutual funds and exchange-traded funds (ETFs)—more than 33 times the amount allocated to equity funds and ETFs." {Emphasis mine}
Traditionally an investors concerned with rising interest rates tries to shorten the duration of their bond portfolios. That is they attempt to shorten the maturity dates of their bonds. They might for example try to have more of their bonds mature within seven years or so. The thinking goes with this is that bonds closer to maturity typically have lower exposure to rising interest rates and hence lower volatility. The trade off is that the closer to maturity the lower the yield. In today's world bonds in this range yield virtually nothing. Investors who reach for yield have to go further out on the yield curve, that is they must go further out on the maturity spectrum or reach for lower quality bonds.
Traditionally investors who made investments in bonds "laddered" their maturities. That is they had certain percentages of bonds that matured over varying degrees of years. A $100,000 might for example have $10,000 come due each year for ten years. The maturing bonds in any given year would be reinvested ten years out and the process would continue for the lifetime of the portfolio. Such a portfolio it was hoped would ride out the normal swings in the bond market.
These are not traditional times.
Today most money that goes into bonds goes into mutual funds or ETFs. Because these are open ended funds that are constantly receiving money and are constantly buying bonds. There is duration {think average yield to maturity} but no maturity for the whole portfolio. Thus, unlike bond portfolios where in a worst case scenario you can quit adding to the portfolio and just wait out the maturity dates, bond funds never come due. That means when rates start heading tbe other way and the bull market in bonds finally ends bond funds are likely going to be in a world of hurt.
We have not been buyers of bonds for some time and where clients have bond funds we are beginning the slow process of liquidating these. Again I don't know if this is an issue for 2013, but it is coming. Don't say you haven't been warned.
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