My Favorite Sector for Summer: Bonds

by Dan Burrows | June 4, 2012 8:45 am

My Favorite Sector for Summer: Bonds

It seems crazy, seeing as the No. 1 rule of investing is to buy low, but bonds — yes, sky-high Treasury debt — might be the best place for safety and returns in the months ahead.

Sure, if you’re tactically minded, the defensive sectors of health care, utilities[1] and consumer staples stocks historically have outperformed from May to October — at least since 1989, according to Charles Schwab and The Leuthold Group. But those bets still will plunge along with a wider market shellacking — they’ll just hold up better than others.

And with the eurozone pulling apart at the seams, slower growth in the U.S., China, India and Brazil, and the specter of another full-blown credit crisis striking fear in investors’ hearts, Treasurys still could have lots of room to run.

On the face of it, it seems totally counterintuitive — the opposite of everything an investor is supposed to do, which is to buy when prices are cheap. The yield on the benchmark 10-year Treasury note has plunged to touch 1.44% in recent sessions — an all-time low. Remember that yields and prices move in opposite directions, and the idea of investing in Treasurys seems like the worst kind of panic, running along with the herd.

The plain and obvious argument is that bond yields can’t possibly go any lower. Prices are too high and poised for a fall.

Eventually, sure. But soon? Not necessarily.

“So many ‘pundits’ ask who in their right mind would buy bonds at current levels,” writes David Rosenberg, chief economist and strategist at Gluskin Sheff[2], whose perma-bull case for bonds has been spot-on and remarkably remunerative. “They were saying the same thing a year ago.”

And all the while Treasurys have continued to pay off. Despite the best first quarter for the stock market since 1998, Treasurys have since caught up, notching a total year-to-date return of 5%. In May alone, Treasurys returned 6.7% versus a 5.8% decline for the S&P 500. Meanwhile, the blue-chip Dow Jones Industrial Average endured its worst month in two years.

Going farther back and looking at Treasurys with the longest maturities, Rosenberg notes that the long end has produced returns exceeding 60% in just the past four years, “and that is with no capital risk.”

Of course, past performance is no guarantee of future returns, but there’s ample evidence that bond yields can go lower. Just look at the sovereign debt of some other stalwart governments, where the flight to safety has been even more pronounced.

The yield on five-year German bunds is less than half than what you get with comparable Treasurys. And even as the 10-year Treasury yields as little as about 1.5%, the yield on the German 10-year bund is down to about 1.18%.

More incredible, the 10-year Japanese government bond is yielding less than 1%. Yes, it’s currently throwing off about 0.8%. Comparable bonds from Switzerland, Hong Kong and Denmark yield less than 1%, too.

Also boosting the case for bond buyers is that inflation is nigh nonexistent. If anything, the markets are worried sick about deflation — and remember that creditors (that is, bond buyers) love deflation. It boosts real returns because when prices drop, every dollar loaned out today gets repaid tomorrow in a currency with more purchasing power.

So it’s actually good news for bondholders that the revision to first-quarter gross domestic product showed a drop in corporate pricing per unit for the second consecutive quarter, Rosenberg notes. Unit labor costs also declined for a second straight quarter, and for three of the past four quarters.

And yet prices and labor costs actually should be going up.

“This is the slowest trend since the third quarter of 2010 and ratifies the bond market view that deflation or at least disinflation momentum is alive and well at a time in the business cycle when price and cost pressures are escalating,” Rosenberg says.

Against that backdrop, there’s still more upside in Treasurys, especially those with the longest maturities, Rosenberg reckons — and note well that he’s been presciently profitable on this call for years.

“The secular bull market in bonds ends once the long end tests 2%,” he writes.

Check out the yield on the 30-year bond, currently throwing off about 2.55%, and it looks like the Treasury bulls still have room to run.

More from this series:

As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.

Endnotes:
  1. utilities: http://investorplace.com/2012/05/my-favorite-sector-for-summer-utilities/
  2. Gluskin Sheff: http://www.gluskinsheff.com/
  3. My Favorite Sector for Summer: Utilities: http://investorplace.com/2012/05/my-favorite-sector-for-summer-utilities/
  4. My Favorite Sector for Summer: Biotech: http://investorplace.com/2012/05/my-favorite-sector-for-summer-biotech/
  5. My Favorite Sector for Summer: Consumer Discretionary: http://investorplace.com/2012/05/my-favorite-sector-for-summer-consumer-discretionary/
  6. My Favorite Sector for Summer: Energy: http://investorplace.com/2012/06/my-favorite-sector-for-summer-energy/

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