Killing Me Softly With His Bonds

Bugra Bakan

“Why are you always so suspicious? – Irene Adler

Should I answer chronologically or alphabetically? – Sherlock Holmes, A Scandal in Bohemia”.

For full time, professional investors, the good news is that there is never a dull moment. There is always a variable, an unknown, a potential chess move someone must be getting ready to make that you may not ready for. There is always that un-turned stone. The bad news is that, you can never allow yourself to get comfortable. If you think you’ve figured it out, ask again because as the saying goes “You can be right on the trade or the timing, but never both.” So before you call yourself a successful investor, accept that there will always be a healthy level of paranoia in your thoughts.

This could not be more applicable for the bond market movement lately. I, among many, have been projecting an end to the 30 year bond bull market with a correction to the downside. Some called it the “great rotation”, referring to asset allocation, shifting from bonds to stocks.

I, also among many, had no idea when this would occur and the speed at which money would move. FED Chairman Ben Bernanke sparked the fuse on this trend by stating that bond purchase program would be “tapered off” and there went the wild fire in bond prices.

Let me share with you some Exchange Traded Bond Fund performances during April – July period. I will note the peak to through dates, with losses in value in percentages.

iShares Core Total US Bond Market ETF (AGG) :    April 29 – July 5          -5.13%

iShares High Yield Corporate Bond (HYG) :              May 6 – June 24         -7.53%

iShares Investment Grade Corporate Bond(LQD):    May 2 – June 24        -8.85%

iShares 20 + Year Treasury Bond (TLT):                   May 1 – July 5           -14.31%

iShares CA Municipal Bond (CMF):                           May 20 – June 4           -9.95%

Now, you will notice, supposedly the “safest” bonds, the long term US treasury bonds got hit the worst with a 14.31% loss, in a matter of a little more than 2 months. Second to the total US bond market ETF, the best performer was the “riskiest”, which is high yield, or non-investment grade, or junk bonds, with a loss of 7.53%.

How can this be? The two main reasons are:

1 – In times of correction, usually, the areas that brought the highest returns also bring the biggest losses. Long term treasuries were the long term champions of the bond market and so they got sold more dramatically.

2 – And more importantly, because of a concept called bond convexity. Without boring you to tears with the math part of this, here is a beginner’s guide to the concept:

To remain competitive with the new issues, existing bond prices fall as interest rates rise. The sensitivity of a bond’s market value to the interest rate changes is called the convexity of the bond. Bonds with higher interest rates lose less in value in times of rising interest rates, and the opposite is also true, bonds with lower interest rates lose more. Think of it this way; if you hold a bond that yields 8%, a rate increase of 1% chips away a lot less from your income, compared to your bond that yields 1%.

So the high yields lost less than the lower yielding bonds.

On the stock side of things, the S & P 500 Index found a reason to give us the long anticipated pull back, again peak to through dates and the loss is: May 21 – June 24 -6.04%

Since this categorical market pull back, stocks and bonds bounced back, especially the US stocks only to reach new highs.

To find the right answers, one needs to ask the right questions and I think the most important questions to ask at this moment are:

1-    Has the great rotation from bonds to stocks started?

2-    Is the pull back in bonds a short term phenomena or the beginning of a longer term trend?

3-    The US stocks have reached an all-time high; so is it time to sell or are there more legs to this trend?

4-    Is there an economic base to this uptrend in the stock market?

The answers to the first two questions, related to bonds, are probably yes and probably it’s the beginning of a longer term trend.

The answer to the last two questions, related to the US stock market, are probably no and yes.

Let me expand on this.

If the FED’s and many economists’ expectations materialize and FED’s record on this should grant them at least the benefit of the doubt, 2016 is the year when things will normalize. This would mean an inflation rate at 2.5-3.5% range, unemployment down to 5-6%, and real economic growth at around 3%.

In Europe, even though it has been spotty, capital markets have shown some signs of stabilizing in their banking and financial systems as well.

If the global economy stabilizes and starts to survive on its own without the life support of central banks, this would push rates higher.

The effect on bonds would be twofold: In the short term, bonds may be oversold and some appreciation in bond prices may be in the cards, but I think the days of longer term bond out performance is most likely over.

The most critical implication of this shift (and I can’t emphasize this enough) will be seen in the investments of the so called “conservative” clients, who are at or close to retirement. If these accounts are allocated overweight to bonds, as the traditional money management strategy would suggest, they may experience bigger losses than a stock heavy portfolio. This factor, the potential rise in interest rates, should be watched closely by all investors because April-May-June period has shown to us that even bonds can experience a waterfall decline in value.

Rising interest rates, like any other variable, may create its own winners and losers. Two implications that come to my mind is the effect on domestic large cap company stocks and emerging markets.

When interest rates in a country rise, this attracts money from overseas that is invested at lower rates, which would shift the supply demand balance and the local currency starts appreciating. In other words,

if and when the interest rates here in the US go up, this could also create a stronger dollar. A stronger dollar is good for importers and price stability (inflation) because imported products end up being cheaper. Exporters however, find it more difficult to sell their products as a stronger dollar would push the prices of their goods. This may cause export revenues of large US companies to shrink and since mid and small size companies may not have this challenge, their stocks may outperform.

Due to the global financial crisis and the low interest rate environment, emerging markets have been able to borrow at rates lower than in the past, which helped them refinance existing loans and start infrastructure projects that would otherwise be too costly. This clearly helped emerging markets’ economic growth and stock prices. Rising interest rates in the developing world may rewind this trade and hot money may leave countries like China, Brazil, Malaysia and Turkey. On one hand, this would hurt their economies and stock prices. But on the other hand, better economies in Europe, US, UK and Japan would spill over to the developing markets as well and this increase in demand may offset the increase in the cost of money. It is too early to call where chips will fall for the emerging markets but for the shorter term, a rising interest rate environment may at least initially be challenging.

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