5 Reasons to Give Bonds Another Chance

by Daniel Putnam | August 21, 2013 10:58 am

That galloping noise you hear is the sound of bond investors tripping over one another to get to the exit door.

This week, TrimTabs reported that bond mutual funds and ETFs have seen $103.5 billion in redemptions since June 30[1] — a whopping 2.7% of their total value. And it’s no wonder: The bond market has been slammed by rising rates across the board, with only the shortest-term (and lowest-yielding) funds able to sidestep the carnage. But now, with major losses already in the books, is it time to give bonds another look?

It just might be.

Here are five reasons why bonds offer a contrarian opportunity for investors and traders alike:

#1: Taper Uncertainty Will Soon Go By the Board

The main issue plaguing the bond market has, of course, been the prospect that the Federal Reserve will taper its quantitative easing policy. The selling has built upon itself amid the ongoing uncertainty, with falling bond prices driving fund outflows, which in turn have caused prices to fall further and fueled a vicious circle. At this point, however, the fact that tapering is going to occur — at some point — is largely factored into market prices.

What isn’t factored in is the extent of the taper — and herein rests the uncertainty that continues to pressure the market.

Nevertheless, the issue that might be getting lost in the clamor right now is that investors are going to gain much more clarity on these issues in the next month. The first hurdle is today’s Fed minutes, which in theory should provide more insight as to the timing and extent of tapering. Then, on Sept. 6, investors have the August jobs report[2] — a key number since the Fed’s decision-making process hinges on incoming economic data. Finally, Sept. 17-18 is the date of the next Fed meeting — and the point, presumably, at which Ben Bernanke & Co. will announce their final decision on the taper.

The consensus expectation is for a reduction of $20 billion to $25 billion per month from the current $85 billion. However, with four weeks to go until the announcement and a key number on its way in the interim, there’s still substantial latitude for a shift. One important result of this ongoing uncertainty is that bonds are having a tough time catching a bid right now.

Once the September Fed meeting is out of the way, however, investors will have much more clarity regarding the outlook for quantitative easing. And, most likely, they will see that the Fed intends to wind down the program in a measured way that’s unlikely to disrupt the markets. The resulting dissipation of uncertainty should begin to make bonds look like a much better buy.

#2: Yields Are Much More Attractive Now Than They Were in the Spring

Already, the yield on the 10-year note sits at 2.81%, vs. 1.63% at the beginning of May. At this level, bonds offer a more competitive option relative to stocks given the yield of approximately 2% on the S&P 500 Index.

Municipal bonds might offer an even better deal for investors in high tax brackets: At its current level nearly 8% below from its spring high, the iShares National AMT-Free Muni Bond ETF (MUB[3]) offers a 4.15% yield for investors in the 33% bracket and 4.60% for those who pay the top 39.6% rate.

Corporate bonds currently yield more than 3.5%, up from the 2.6% range in early May, while the yield on high-yield bonds has risen to 6.55% from 5.24% on May 9 (according to the Federal Reserve Bank of St. Louis database).

A hockey-stick pattern for the ten-year yield[4]

A hockey-stick pattern for the ten-year yield

Just because yields are higher doesn’t mean they can’t go higher still, but the news flow has the potential to grow more positive in the months ahead.

For instance, a key factor weighing on the bond market has been the consensus view that economic growth is improving. In recent years, however, these periods of rising optimism about the economy generally have proven to be false starts. Or as Bill Gross put it yesterday, “Faster growth ahead? Show me.”[5]

In fact, higher bond yields can serve as a brake on the economy in their own right if they contribute to a slowdown in the housing market. Clearly, the potential for the largest surprise on the economic front is now slower-than-expected growth — which of course would be a positive for bonds.

Other potential supportive factors include surprises stemming from the European elections, a further slowdown in China’s economy, uncertainty created by this autumn’s U.S. budget battles or protracted stock market weakness.

While the odds are against all of these individually, the possible “surprise” again works in favor of bonds in all cases.

#3: The Short End Is Pinned

The Fed, in keeping the fed funds rate pegged at zero, is going to depress the short end of the yield curve indefinitely. This has caused the yield curve to steepen considerably, putting it at its steepest incline in two years — a shape that isn’t supported by an environment of low growth and tame inflation. While a further steepening is certainly possible, the current shape of the yield curve should soon begin to act as a drag on longer-term rates.

#4: The Rate of Yields’ Increase Has Reached Historic Levels

Barry Ritholtz at the Big Picture posted this chart[6] on Monday, which shows that the rate of change in Treasury yields are (almost literally) off the charts in terms of the pace of their increase relative to history.

#5: Fund Flows Have Reached Extreme Territory

The exodus from bond funds, as noted above, is a sign of extreme distress among individual investors — an important contrary indicator. Bond ETFs make up half of the top 10 funds in terms of net redemptions since June 1, led by the nearly $4 billion in outflows from the iShares Investment Grade Corporate Bond ETF (LQD[7]). This presents contrarian-minded investors with a chance to go against the herd.

How to Play It

Add it up, and the most recent downleg offers the chance for longer-term investors to consider adding to positions, and for traders to prepare for a shot from the long side.

Those looking to generate quick returns usually look first to iShares 20+ Year Treasury Bond ETF (TLT[8]), but another fund to consider is PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ[9]). The fund has consistently demonstrated stock-like volatility  due to its ultra-long duration, and it has done so without the tracking problems associated with leveraged ETFs – traders’ other top choice for bond-market beta.

The Bottom Line

Stepping up and buying bonds in the teeth of tapering fears is a difficult decision to make, but the best investment ideas usually are. Consider this a prime opportunity to turn bond investors’ fear to your advantage.

As of this writing, Daniel Putnam was long ZROZ.

  1. have seen $103.5 billion in redemptions since June 30: http://www.reuters.com/article/2013/08/19/investing-fundflows-trimtabs-idUSL2N0GK19320130819
  2. August jobs report: https://investorplace.com/2013/08/sept-6-jobs-report-fed-tapering/
  3. MUB: http://studio-5.financialcontent.com/investplace/quote?Symbol=MUB
  4. [Image]: https://investorplace.com/wp-content/uploads/2013/08/tnx.gif
  5. “Faster growth ahead? Show me.”: https://twitter.com/PIMCO/statuses/369829893036855296
  6. this chart: http://www.ritholtz.com/blog/2013/08/bond-yields-mean/
  7. LQD: http://studio-5.financialcontent.com/investplace/quote?Symbol=LQD
  8. TLT: http://studio-5.financialcontent.com/investplace/quote?Symbol=TLT
  9. ZROZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=ZROZ

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