Bonds Face Three Powerful, Negative Forces – Time to Consider the Warning Signals

Monday, April 5, 2010

Good Friday was bad for bonds. In spite of the yearlong demand flow by investors, fundamentals keep chipping away at bond prices. Here is what’s wrong with bonds and why you should consider avoiding them…

First, a primer to ensure we’re on the same page

Bonds are in the “fixed-income” category, and that label describes their weakness. Their return comes from a series of unchangeable (fixed) income payments, followed by a large “face value” payment (usually $1,000 per bond) at the bond’s “maturity” date. That may sound tempting in uncertain times, but when conditions improve, bonds often don’t. (For this discussion, I am assuming the bond issuer’s fundamentals are sound and remain so.)

Because the payments are fixed, a change in yield (called “yield to maturity”) requires the bond’s current price to change – inversely. For example, if newer bonds offer higher yields and interest payments, older bonds (with smaller interest payments) need lower prices to make their yields competitive.

Real life example

In my first two Investment Directions write-ups, I explained the risks of buying bonds and recommended avoiding them and investing in short-term holdings instead – a message I have repeated many times since. (See “Consider Avoiding Bonds for Now” and “Making Money with Low Interest Rates”; September 21-22, 2009.)

I used the example of the 10-year US Treasury note yield rising from the then-current 3.4% to 4.4% to show how a price decline could more than offset the additional interest earned. Well, we’re half way there already. In the past 6+ months, the 10-year US Treasury note yield has risen from 3.4% to 3.9%. End result for a $10,000 investment: About $180 in interest less a $390 price decline equals a $210 loss. In percentage terms: 1.8% – 3.9% = -2.1%. Clearly, a low-yielding money market fund would have been better.

The outlook: The trend continues

So, what’s in store? Likely, more of the same. There are three powerful, negative forces that will be at work on bonds in the future:

First, better economic conditions could raise inflation worries. The cause? A growing economy produces increased money creation (through bank lending) plus it gives corporations more pricing power. These changes can boost inflation forecasts, particularly from today’s low levels. Rising inflation expectations, in turn, typically produce higher bond yields.

Second, bond demand looks overdone. I think this period qualifies as a bubble because of size if not enthusiasm. Investors have flocked to bonds for two primary reasons: to increase their income returns and to invest their risk-oriented assets while avoiding the US stock market. There are persuasive motivators in the wings that could shrink, even reverse, this demand flow: (1) increasing short rates, (2) weak bond returns and (3) a rising interest in the US stock market.

Third, the supply of bonds is large and growing. The Fed wants to sell its $1+ trillion in bonds, the US Government needs to issue hundreds of billions more and many other issuers are active (some are churning out large amounts of bonds, others are warming up).

So… These three forces need to be taken seriously, and bonds remain an investment to consider avoiding

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