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THE GREAT BULL MARKET IN bonds is dead. Long live the bond bull market.
So declared the Bond King, otherwise known as Bill Gross, the founder and co-chief investment officer of Pimco, the manager of the world's biggest bond fund.
By the technical analysts' textbook definition of a bull marketâ??a succession of higher highs and higher lowsâ??that may be the case for bonds. In terms of yields (which, of course, move inversely to prices), the benchmark 10-year Treasury note yield had been in broad downtrend for nearly three decades since it peaked over 15% in September 1981. The absolute bottom in the 10-year Treasury, a hair over 2% touched at the depths of the financial crisis, still stands.
Conversely, in the two subsequent back-ups in the yield since then, the 10-year note hit 3.86% in June of 2009 and then 3.99% last April. So, the pattern of successively lower highs (in yields) has been broken. And since the most recent low of 2.39% in early October, the 10-year has moved up 25 basis points, to 2.64%. Thus, the benchmark note has set a higher high and a higher low in yield, which technicians would say indicates the trend in yields no longer is downward.
The end of the bull market does not necessarily mean a bear market has started, counters James Kochan, a bond-market veteran whose career predates the beginning of the bond bull market and now chief fixed-income strategist of Wells Fargo Advantage Funds. Constant readers of this space may also recall he made "The Case for Bonds" in this space last March, just as bearishness on bonds and yields were at their peak. Those who listened enjoyed a big bond rally while stocks slumped.
With inflation and short-term interest rates likely to remain low, bonds outside of Treasuries still provide value, Kochan says. "This is the income phase of income investment cycle, not the bear phaseâ??yet," he adds.
That means looking to sectors of the bond market where income returns more than offset the risk of rising yields and falling prices. In the corporate sector, that means the high end of high-yield market with credit ratings of single-B or double-B, Kochan says.
Even if Treasury yields were to rise a 100 basis points (a full percentage point), the extra increment of yields would more than offset the price reaction. Indeed, rising Treasury yields would likely reflect a more robust economy, which would benefit the high-yield sector. But, he adds, the speculative end of the junk market with triple-C securities has gotten overvalued.
Municipal bonds also offer good value and income, Kochan adds. Yields on tax-exempt bonds moved up sharply in tandem with Treasuries in recent days, with triple-A munis yielding nearly as much as taxable U.S. governments.
Kochan prefers longer maturities because of the steep muni-yield curve (that is, long bonds yield a lot more than shorter maturities.) for instance, 30-year triple-A munis yield 4.20%, markedly more than 2.56% for 10-year bonds or 1.18% for five-year bonds. He prefers the yield pick-up in the single-A to triple-B muni credits.
A rising interest-rate environment isn't all bad for bond investors, says Dan Fuss, another market veteran who was in the trenches long before the generation-long bull market began, and now manager of the Loomis Sayles Bond Fund and other institutional portfolios for the Boston-based money manager. Higher yields doubtlessly mean lower bond prices. But higher yields also mean higher yields, and after all, income is what bond investors are after.
A rising yield trend works to the advantage of the bond investor looking to fund a future liability, such as a life-insurance company, a pension fund or an individual with a retirement account. As bonds mature or pay interest, the cash flows get reinvested at higher interest rates. Over time, this reinvestmentâ??the interest on interestâ??is the biggest component of bond returns. During the 1970s, the worst of the bond bear market that actually began in 1946, was actually a good time for fixed-income investors as the incomes from their portfolios rose steadily.
The key, Fuss explains, is both to get the credits right and to have liquidity available to take advantage of opportunities. The one thing you don't want to do is to hew to the conventional indexes and look for opportunities elsewhere. And given the preponderance of U.S. government debt in the market, Treasuries dominate the main indexes such as the Barclays Aggregate Index.
By following the convention of weighting sectors by the volume of securities outstanding, bond indexes are dominated by the biggest borrowers. In equities, given the biggest capitalization names the heaviest weight makes some sense. But to increase the weighting of the borrowers who plunge the deepest in hock, such as the U.S. government, seems a daft investment strategy.
In any case, rising bond yields means that a portfolio can generate increasing income from each unit of investment, Fuss explains. Cash flows can be invested in steadily higher yielding bonds and boost the income from a fixed-income portfolio.
Moreover, over time, bonds' lives shorten as they approach maturity. So, in two years today's five-year note will be a three-year maturity. Given the steep slope of the yield curve, that works to the investor's advantage.
Assume yields are static over the next two years. A five-year Treasury yielding 1.25% would become a three-year note in two years' time, with a yield of 0.65%. Now assume yields are doubled at the short end over that span; today's 1.25% five-year note becomes a 1.30% three-year note in two years. The change in price is negligible, but the investor garners a vastly higher yield over two years than the 0.12% that three-month Treasury bills pay.
In other words, sticking to cash exacts a huge penalty compared to the yields available by venturing into the bond market. Which is why there's been an influx into bond funds. But much of the surge has been into relatively conservative short-to-intermediate funds at one end of the spectrum or high-yield or emerging-market bond funds at the other. Both are much less sensitive to interest-rate swings than the 10-year or 30-year Treasury, which get the media attention.
That means if the great bond bull market is over, fixed-income investors who sought safety in short-intermediate corporate or municipal funds or high yields in junk or emerging markets should fare relatively well. Indeed, the historical record shows that intermediate bonds provide something like 80% of the return of long bonds with a small fraction of risk of long bonds. What would be most vulnerable are long Treasuries.
Having an advantage in absolute yield will be key, says Fuss. Once again, Fuss is going his own way. The Loomis Sayles fund is heavily weighted toward junk as well as Canadian government bonds, which offer higher yields in a strong currency than their U.S. counterpart. And he's nibbling at Ireland's bonds, which he calls a short-term downgrade candidate, but a long-term upgrade.
During the bull bond market, the single best thing to own was the Treasury long bond, which outperformed stocks during that span. Now it's different. Even if yields don't rise, they're not on a one-way downward slope. And that's not a bad thing if it increases income on a bond portfolio.
E-mail: randall.forsyth@barrons.com
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