US Treasury yields rising from a cyclical low…
In early October, the 10-year Treasury bond yields reached as close to zero in this cycle as they are going to get, at 2.4%. I think this figure will prove to be a low that will hold for a very long time. Since then, yields have bounced back to the current–and still low–3.2%.
What has changed in the past two months? Three things:
1. The US economy is showing clearer signs of life. These are evident in macroeconomic indicators like the money aggregates and in bank lending, as well as in announcements by individual company managements and by retail and other trade associations.
3. Bond buyers may be beginning to realize just how expensive bonds are. If you figure that a ten-year bond should give you, say, a 2.5% real yield + protection from inflation, the 2.4% nominal yield implies no inflation–basically a dormant economy–for the next decade.
Roll the clock back to October 7th. Suppose you bought a 10-year bond from the government on that day. For your payment of $1,000 to the Treasury, you would have gotten the promise of interest payments of $24 a year, or $240 in total, plus return of your $1,000 ten years hence.
Today, if you did the same thing you’d get the promise of $320 in interest plus your principal back, or about 6.5% more.
If today’s bond is worth $1,000, then October’s must be worth less–maybe 5% less. In other words, if you sold the October bond in the secondary market today, you’d only get about $950. You’d have a capital loss of $50.
the response to the prospect of losses varies…
In all cases, the seller of bond products probably stresses that we don’t know for sure what will happen in the future.
For the holder of individual bonds, there may be no getting around the fact that the holder has a minimum requirement for current income, which may require keeping longer dated bonds despite the prospect of capital loss. In this case, a financial advisor probably stresses this fact, and also tries to point out that “you haven’t lost money, you’ve just lost time.” In other words, the advisor will point out that–unlike the case with stocks– the stream of interest payments will gradually offset any capital loss. Also, if you hold the bond to maturity, you’ll get your principal back. These words may give some psychological comfort.
In the case of bond mutual funds, the marketing departments of the major bond managements companies have been working overtime during the past couple of years spreading the story of the “new normal.” That’s the idea that the damage done to the world by the financial crisis was so severe that global economic growth will be close to zero for many years. Therefore, bond yields will remain at emergency-low levels for a very long time. It’s hard to know if the bond management companies actually believed this, but it never made any sense. And, other than for Europe, we have clear evidence that it’s wrong.
As a result, the bond fund marketing pitch has changed. The fund managers are constantly trading their holdings–and have, to my (equity-oriented mind) surprisingly small accumulated unrealized gains to show for this–so there’s no equivalent of holding to maturity and getting your principal back. What bond managers are saying now is that the global bond market is so wide and deep and has so many different products that there are opportunities to ride through the upcoming rise in rates with minimal or no losses.
Of course, if you listen carefully, the companies aren’t saying that they can do so–like equity managers, most bond managers serially underperform their benchmarks–just that it’s theoretically possible. Egos buoyed by close to three decades of rising markets, they may believe they can do so and are being held back in their public statements by their legal departments. But if so, I diagnose this as a case of the ultimate Wall Street sin–confusing brains with a bull market.
ETFs fall into two categories, actively managed and index. Index funds have no scope to change their composition. ETFs focused on longer-dated bonds will feel the brunt of higher rates. Management companies will, as usual, say nothing. For actively managed ETFs, the marketing pitch will be the same as for mutual funds.
what they won’t say
During times of rising interest rates, stocks have typically been flat to up, while bonds have made losses. (Stocks are negatively affected by higher rates, but rising rates of profit growth have had a counterbalancing effect.)