My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s. He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals. His 4Q11 letter to clients gives a polished industry veteran’s view of the current global economic situation and its implications for bonds. He’s relatively bearish.
The analysis is very worthwhile reading. It’s long enough, however, that I’m going to publish it in three posts, all sans charts. Here’s the first, an outline of the current bond situation:
Is it time to get off the bus?
2011 was a remarkable year. The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities. We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors. The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse. And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene. The prize in this case was a whopping 30% return from investing in long term US Treasury bonds. And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds. But as all moviegoers know–the third installment in a series is usually a dud.
We don’t think the numbers add up for another bond market rally in 2012. Last year’s increase in bond prices lowered yields sharply. For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%. This compares with 4.1% a year ago. The smaller yield means a smaller cushion against any price decline. Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates. The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier. Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%. If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change). Of course, the returns from bonds with shorter maturities would be less damaged. Nonetheless, there would be plenty of red ink for all.
If you think current bond market returns aren’t very generous, you’re right. The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record. In fact, they were lower than the rate of inflation. This has rarely occurred. This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.
The bond market has reached these low levels because of:
(1) fears of a European banking crisis,
(2) the free money policies of the Federal Reserve, and
(3) modest non-government domestic credit demands.
The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets. If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.