Is the Bond Market Changing Direction?

Tuesday, September 14, 2010

Whether you call it a bubble or not, investors’ love affair with bonds may be ending. Longer-term bond losses in the last three weeks have been about one-half year’s interest income.

It may not seem possible. After all, corporate bond yields rose only 0.22% from their 3.74% historic low on August 24 to 3.96% last Friday (see Bloomberg article below). Such is the “magic” of long-term bond arithmetic: Small interest rate changes produce large price moves.

The question is:

What are the reasons for a change now, and what might it mean?

I covered some of the dynamics in my August 24 article, “Scrambling for Income? Avoid Being Carried Away by the Crowd.”

Corporations are savvy bond issuers, selling new bonds at interest rate lows. News reports have discussed the recent large issuances. Looks like they did it again.

And investors? Looks like many played their role again, too: Buying at the top. Take a look at a couple of the examples listed by Bloomberg in “Bond Buyers Getting Burned by Going Long as Yields Climb” (By Shannon D. Harrington and Tim Catts – September 13):

“Corporate bonds due in 15 years or more have lost 3.15 percent since Aug. 31….

“Longer-dated bonds of drugmaker Abbott Laboratories … declined 4.43 percent, while debt from … International Business Machines Corp. fell 4.08 percent.”

Nothing deflates a bubble and reverses a trend like a sudden bout of negative performance. It freezes new buyers, breaking the investment fad cycle of higher prices = raised expectations = more buying.

Can’t this move “re-reverse” with the trend taking over again?

Sort of. There can be an improvement accompanied by a feeling that the trend is still in place. On the supply side, recent buyers may not sell, being unwilling to throw in the towel and take losses so quickly. In addition, corporate issuance likely will taper off. On the demand side, new investors might return when rates rise a bit more, seemingly offering a special opportunity.

Moreover, it’s probably too early for commentators to say the trend is over. They may even write about its eventual return. For example, from The Wall Street Journal, “U.S. Treasurys Ripening for Another Rally” (By Deborah Lynn Blumberg, September 13):

“The downturn in the Treasury market is likely a short-term phenomenon, with plenty of catalysts for a bond-market rally lurking just around the corner.”

What’s the problem, then?

The cycle of buy-buy (because waiting only means a lower yield) looks to be broken. New buyers will probably be more price-conscious, not wanting to pay top dollar (i.e., getting the lowest yield) on their bond purchases.

Moreover, indications are that the fear of deflation is diminshing. The loss of that driver means today’s historically low yields really stand out. A shift from a deflationary to even a low inflationary outlook would mean the current expectation of a purchasing power increase would flip to a decrease. Therefore, from the expectation of a gain bolstering the historically low interest rates to a loss shrinking them further. Investors would be back to their prior understanding that part of the interest payments received, after taxes, must be saved to cover the purchasing power loss.

Note: “After tax” income is necessary because the IRS doesn’t recognize purchasing power loss. For example, this year (2010) an investor buys a 10-year bond for $1,000 in a taxable account, holds it the 10 years during a time of 1% inflation, collecting interest on which taxes are paid, and then is repaid the $1,000 in 2020. The IRS says no gain or loss, even though that $1,000 in 2020 is the equivalent of only about $905 in 2010 dollars. To be even, that $95 purchasing power loss has to be made up from the after-tax interest received during the 10 years.

Therefore…

A key point: A change from a deflationary to an inflationary outlook, no matter how small the expected inflation, could have a dramatic effect on investor thinking about the adequacy of today’s still-low interest rate levels.

So… This is an important time to be objective about owning bonds. By focusing on facts, not fears, we can make investment decisions that will serve us well. This is particularly important when evaluating long-term bonds paying historically low interest rates. If the bond market trend is shifting, yields could rise further, causing prices to fall significantly. Throw inflation into the mix, and risk rises, giving bond holders a “double whammy” of price AND purchasing power declines.

Tags: , , , , , , , , ,

Leave a Reply

You must be logged in to post a comment.

Search

John Tobey on Seeking Alpha

Seeking Alpha Certified

September 2010
S M T W T F S
« Aug   Oct »
 1234
567891011
12131415161718
19202122232425
2627282930