This article was last updated on July 3
Apparently the bond market is heading for a big time crash after a nearly 20 year boom. Last month saw a post-2008 (financial crisis) record outflow out of bond funds (mutual and ETF) as prices tumbled. The main driver behind this is the expected rise in interest rates driven by comments from the Federal Reserve, which uses interest rates as a lever to boost and contract liquidity in the economy. With the economy improving, the Fed plans to scale back on its efforts (quantitative easing) to stimulate the economy.
But first, a Bonds 101 course for those unfamiliar with bonds or want a quick refresher. Bonds are issued by institutions, governments and even ultra-rich people to raise money (think of it as an I.O.U) in return for a specified rate of return (coupon) and eventually the principle at maturity. For example, a $10,000 bond with a 6% yield will pay investors $600 a year in coupon payments and $10,000 at maturity. Bond prices are driven by a variety of factors such as interest rates, inflation, duration and risk of the issuing party. Interest rates have the most variable effect on bond prices because they essentially set the benchmark for what the bond should be returning. Generally bond prices move inversely to interest rates and thus the expectation of higher interest rates drive down bond prices. Off course if you hold a bond to maturity, prices are somewhat irrelevant since you already know your coupon and principal payment.
Reasons for the bond sell-off to continue
- Market bears say losses are just getting started because yields barely exceed inflation, leaving little relative value in bonds as the global economy improves. Fixed income was there to provide stability and yield, which it did for many years but is no longer the case. With coupons payments/yields on bonds at historic lows, bond investors are seeing little return on their money. Real yields on 10-year Treasuries, after subtracting the annual inflation rate, are just over 1 percent, compared with the 6.4 percent aggregate earnings yield of U.S. stocks, according to data compiled by Bloomberg
- Federal Reserve Chairman Ben S. Bernanke laid out possibilities for reducing the $85 billion in monthly bond purchases supporting the economy. This cut-back in central back spending will push actual and expected interest rates higher and continue to pressure bond price downwards as investors demand higher yields
- Bond funds saw $62 billion of withdrawals as money market mutual fund assets rose by $8 billion during the last month. Investors often retreat to money market mutual funds during times of financial stress, accepting lower yields compared with bonds in exchange for higher liquidity. This is a red flag for the bond market, particularly if the trend continues
Why the current fall in bond prices may only be temporary
- Bond bulls see the higher rates as a buying opportunity and current fall in prices as a temporary pull back driven by market and investor over reactions
- The bond market may receive support from financial institutions, which will need to buy as much as $5.7 trillion in safe assets including government bonds by 2020 to comply with the Dodd-Frank Act
- The impact from a reduction in the Fed’s asset purchases is far too overstated. It may intact be healthy because trillions of dollars of stimulus have failed to spur much credit growth and economic activity
- Inflation, according to the Fed’s markers, is around 1% and that’s far from its “target” of 2% to 2.5%. So the Fed’s easing may be less severe and slower than planned, particularly if the economy shows signs of slowing in the later half of the year
The basic premise of investing in bonds is to diversify your portfolio which is normally equity (stock) heavy. Most non-professional investors rarely invest solely in bonds. Which is why all the latest news and speculation about crashing bond markets should be taken with a grain of salt. As long as you have a diversified position in bonds (which can be obtained through a variety of low cost bond funds or ETFs) you should be fine and have a good hedge if stocks tumble again. Bonds still remain the best, if imperfect, foil to stocks.