“The bond market is doomed!”
If you read the financial media, you’ve seen that line in various forms every day for years. But here’s the real development occurring beneath the headlines: The bond market actually has been falling for nearly eight months now; the losses have just been mild thus far.
This slow-motion correction might provide a preview of what’s to expect in the years to come.
The Rolling Correction
Every segment of the bond market is now trading off of its high, but — in an interesting twist — these highs have all occurred at different times.
U.S. Treasuries were the first segment of the bond market to top out, when the yield on the 10-year note reached its nadir of 1.4% on July 24. Since then, it has moved higher in fits and starts to its Thursday close of 2.03%. Investment-grade index funds such as Vanguard Total Bond Market ETF (NYSE:BND) and iShares Core Total U.S. Bond Market ETF (NYSE:AGG), which carry a heavy weighting in Treasuries, also hit their high-water marks on that date.
So far, the downturn has been fairly modest outside of the most rate-sensitive Treasury funds. On a total return basis, BND and AGG have suffered losses of 1.4% and 0.3%, respectively, since their July 24 peak. Intermediate-term Treasuries have taken a slightly bigger hit, as measured by the -2.5% return of iShares Trust Barclays 7-10 Year Treasury Bond Fund (NYSE:IEF).
The story is different on the long end, however, where investors have felt much more pain. iShares Trust Barclays 20+ Year Treasury Bond Fund (NYSE:TLT) has shed 11.3% since July 24, while PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSE:ZROZ) — perhaps the most rate-sensitive ETF on the market, and one that experiences almost stock-like volatility — has taken a hit of 18.7%.
The reason for the return differential among these various funds is straightforward: Investors know the Federal Reserve is going to keep short-term rates pinned near zero indefinitely, so any upward movement in yields can only occur among longer-term bonds. The result has been a steepening of the yield curve since the July peak, as expressed by the 5.5% gain for iPath US Treasury Steepener ETN (NYSE:STPP) in that time.
After Treasuries hit their peak on July 24, the rest of the bond market held in for two months until mortgage-backed securities peaked on Sept. 25. Corporate bonds and emerging markets debt followed a few weeks later, hitting their highs on Oct. 15 and 17, respectively. Municipal bonds held their ground until Nov. 30, when concerns about possible changes to rules regarding munis’ tax exemption snuffed out the sector’s post-election rally. The final holdout was high-yield bonds, which managed to continue climbing until Jan. 24 before finally rolling over.
Thus far, the losses in these market segments have been fairly benign, as measured by the performance of the major ETFs from their respective peaks through March 14:
iShares Barclays MBS Bond Fund (NYSE:MBB): -1.1%
iShares iBoxx $ InvesTop Investment Grade Corp. Bond Fund (NYSE:LQD), -2.1%
iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB), -2.9%
iShares S&P National AMT-Free Municipal Bond Fund (NYSE:MUB), -3.0%
iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG) 0.6%*
Why this rolling correction? Aside from municipal bonds, where shifting sentiment regarding the fate of federal tax policy has been the key driver of performance, these results likely represent a classic case of the interplay between fear and greed.
In the Treasury market, fear became the dominant force sooner because low yields made their risk/reward profile the least attractive among the major bond market segments. In contrast, the higher-yielding areas of the market have been able to hold on longer amid investors’ continued thirst for yield in the “risk-on” environment.
This is underscored by the fact that high-yield bonds have managed to rally in conjunction with the stock market in the past month, even as other areas of the market have continued their downward path.
What This Says About the Future
This gradual correction in the bond market makes sense in that it’s exactly what the Federal Reserve wants to see — and that, after all, is the most important driver of performance.
The Fed has put itself in a box through its policies of ultra-low interest rates, quantitative easing and Operation Twist, all of which have helped push rates far below their natural levels. Now, Bernanke & Co. are moving closer to the point where they will need to begin the process of unwinding the stimulus with minimum market disruption.
This paper, published by the Fed late last year, lays out the game plan. In the period from 2014 through 2018 — a date range that could obviously change based on incoming data and new events — the Fed is looking to take a gradualist, four-step approach of ending the reinvestment of interest on the bonds it already owns. It communicates the need to raise the fed funds rate — eventually raising it in a gradual fashion, and finally, beginning the process of selling the securities on its balance sheet.
Why this slow-motion unwinding? The obvious answer: to avoid torpedoing the bond market.
The Fed knows the markets can handle an extended period in which rates gradually return to normal levels, and that this process actually would be a longer-term positive by restoring normal monetary conditions in the U.S. economy. On the opposite end, rapid policy shifts and surprises would lead to disruptions in the capital markets and make the process of unwinding more difficult to accomplish.
In this sense, the current conditions in the bond market are exactly what the Fed wants to see — which means that this grind lower is likely to persist.
Keep this in mind as you adjust the allocations in your portfolio. While bonds are unlikely to experience a catastrophic collapse that many are expecting as long as the Fed can keep its finger on the “buy” button, but a multi-year period in which returns are in the 1-2% range, plus or minus a percentage point, is just what the Fed wants. Adjust your expectations accordingly.
*HYG’s return is still positive since the income has offset the price decline from the peak.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.
