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BONDS HAVE BEEN GETTING worse press than Toyota recently. You can't pick up a financial publication these days that doesn't ominously warn of rising interest rates and how they will decimate the fixed-income investments to which individual investors have been flocking.
"The Big Bond Bubble" is spied in last month's Smart Money magazine (which, like Barrons.com, is published by Dow Jones, a unit of News Corp.) "Investors have bought bonds like they've been going out of style. But things could turn ugly fast," the monthly contends.
Similarly, Smart Money columnist James B. Stewart similarly warns investors to "Prepare Your Portfolio for Higher Rates," which "typically ravage the value of fixed-income assets like bonds."
And Monday's Wall Street Journal quotes a money manager that "bonds could be among the worst-performing investments this year."
But a few bond pros beg to differ.
Rising interest rates remain a forecast and not a certainty. Even if the Federal Reserve begins to push up its short-term policy rates from, that doesn't necessarily translate into significantly higher yields -- and therefore lower prices -- for intermediate- and long-term bonds.
The bear case for bonds would appear to be obvious. The Fed at some point will raise its target rate for overnight federal funds from the current rock-bottom range of 0-0.25%. Even though the central bank has said it intends to keep the fed-funds target at very low levels "for an extended period" -- which would extend well into the second half of the year -- some increase eventually is inevitable. Indeed, maintaining a near-zero policy rate already risks a rise in inflation.
Moreover, the Fed is due to wind down its purchases of $1.25 trillion in mortgage-backed securities issued by federal agencies Fannie Mae (FNM) and Freddie Mac (FRE) along with buys of $175 billion of direct agency obligations. Meantime, the massive federal deficit means the Treasury will be spewing out trillions of dollars of bills, notes and bonds annually for as far as the eye can see. The quantity of state and local debt is going up while its quality is deteriorating because of their well-advertised fiscal problems. And while corporations' balance sheets are in good shape, their bonds' margin of safety have shriveled as yields have plunged.
Robert Kessler, who heads the eponymously named Kessler Investment Advisors of Denver, takes issue with the assertion that big budget deficits will raise interest rates or that inflation poses a clear and present threat. Big budget deficits have been empirically associated with falling bond yields, as during early 1980s.
Indeed, the quarter-century downtrend in the Treasury 10-year yield remains intact, he continues. Despite the reversal in this benchmark yield last year, from a low of 2% at the depths of the credit panic to nearly 4%, a chart shows the downward sloping channel stretching back to 1985 has not been violated. Moreover, since inflation and interest rates historically don't bottom until two years or more after the end of a recession, still lower lows are possible, Kessler concludes.
Even if the Fed were to raise the funds rate, bond-market veteran James Kochan of Wells Fargo points out that does not necessarily translate into an equivalent increase in bond yields.
In the past 30 years, there were six instances of Fed tightenings, and in five of them, the yield curve was quite steep; that is, the graph of interest rates of increasing maturities had sharply upward slope. In those cases, the funds rate was increased by 100% (in other words, doubled), while the yield on the two-year Treasury note was 40%.
For the 10- and 30-year maturities, the yield increased averaged only 8% and 5%, respectively. In three of the cycles -- 1987, 1999 and 2004 -- the 30-year bond yield remained essentially unchanged.
On an absolute basis, Kochan continues, the current yield curve with a 450 basis-point (4.5 percentage point) difference between the three-month bill and 30-year bond yield. But with short-term rates pinned nearly at zero, the long bond yields 45 times as much as the bill, a far cry from 1992, when the bond yielded 2.5 times as much as the bill. As a result, he contends, the yield curve should flatten at least as much as in past cycles.
If the two-year note yield were to rise to 3%, from 0.8% currently, the 10- and 30-year yields might rise 50 and 25 basis points, respectively, to 4.1% and 4.8%. Over a two-year time frame, the total return of the two-year note would be 1%, 2.75% for the five-year note, 4% for the 10-year note and 5.75% for the long bond, Kochan estimates.
"To be sure, there is no guarantee that this Fed tightening cycle will mimic the previous cycles, but history strongly suggests that investors who now hold only 'safe' positions in cash substitutes will earn far less over the next year or two than those who own the longer maturities or funds in both the taxable and municipal markets," says Kochan.
While the very steep yield curve already incorporates expectations of higher interest rates, investors needing both current income and stability of principal face a tradeoff between the two. No longer can a retiree or a small school or church endowment count on 4% or 5% on a certificate of deposit to meet those dual goals. Now, to cite Will Rogers' aphorism, they have to choose between return on capital and return of capital.
Highly rated funds that juggle those two, often-conflicting goals include Sit U.S. Government Securities (SNGVX), which carries Morningstar's highest, four-star rating. The fund has a 4.19% yield from a portfolio of mainly agency MBS with a duration under two years. Translation: it has low credit and interest-rate risk. RidgeWorth Intermediate Bond (SAMIX), which gets four stars from Morningstar, has lower risk than its peers with high returns.
Investors who sit in cash may think they're passively sitting on the sidelines. But, as Kessler points out, accepting nil returns on cash equivalents actually is an active decision to forego current returns in favor of higher yields and lower bond prices in the future. Given the near-zero short-term rates and the steep yield curve, the opportunity cost is steep.
Comments: randall.forsyth@barrons.com
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