4 Reasons Why It’s Safe to Buy Bonds Again

With Washington out of the headlines, there's little standing in the bond market's way

The debt ceiling crisis may not have caused significant downside in the bond market but, if last week’s action was any indication, it almost certainly postponed some buying.

A release of pent-up demand led to a rally across all segments of the bond market last week, bringing year-to-date returns much closer to the break-even point.

Does this mean it’s safe to buy bonds again?

A Market Well Off Its Lows

To start, here are some numbers to provide a sense of where the bond market stands in terms of its 2013 returns. Since touching its low for the year on Sept. 5, Vanguard Total Bond Market ETF (BND), which tracks the investment-grade Barclays Aggregate Bond Index, posted a gain of 2.6% through Friday’s close. That helped BND narrow its year-to-date loss to around 3%.

Negative returns are certainly nothing to celebrate, but the loss is fairly benign given the level of consternation that has surrounded the bond market this year.

And the returns in credit-sensitive sectors have been even stronger since the Sept. 5 low, as shown in the table below.

Sector ETF Ticker Return, 9/6 – 10/18
Investment-grade corporates iShares Investment Grade Corporate Bond ETF LQD 3.8%
High yield iShares High Yield Corporate Bond ETF HYG 3.5%
Emerging markets iShares J.P. Morgan USD Emerging Markets Bond ETF EMB 6.1%
Emerging market corporates WisdomTree Emerging Markets Corporate Bond Fund EMCB 6.1%

Important Tailwinds for Bonds

While the market can’t keep posting returns of this magnitude, it appears equally unlikely to suffer the kind of losses that occurred in May and June. Four important positive factors are supporting the market as we move toward 2014, signaling that the recent rally is more than just a dead-cat bounce:

Better news flow: Two key issues that have weighed on the market in 2013 were the threat of Fed “tapering” and, more recently, the uncertainty related to the debt ceiling. Now, both of these issues appear to be off the table until 2014. What’s left for the bond market is a backdrop of low inflation, slow growth and the supportive policies of the world’s central banks — the same positive combination that drove returns through the first four months of the year.

Less influence from weaker hands: Another favorable factor is that the pre-selloff froth has largely been washed out of the market, as evidenced by the massive fund outflows that occurred during the summer. The result is a market that should now be controlled by a stronger set of hands — and hopefully, one that also has a longer-term focus and a better sense of the risks.

Slower growth: The combination of the weak September employment report, along with concerns about the potential impact of the government shutdown, is leading to a weaker outlook for the economy. If growth indeed comes in below expectations, it will push out the anticipated start of tapering further into 2014 — a development that would only help the bond market.

The historical odds: Much was made about the possibility of a bond bear market at the start of this year, but a downturn in bonds is a different animal than a bear market in stocks. This record of historical returns — compiled by Aswath Damodaran at New York University’s Stern School of Business — shows that from 1928 to 2012, the 10-year Treasury bond had only 15 down years. The average return in these down years was -3.73%, illustrating that even longer-term issues have exhibited only modest downside even in their worst years … and that the concerns about bonds have been somewhat overdone.

On the other side of the ledger, the fact remains that rates continue to be artificially depressed by Fed policy. While the normalization of this policy is likely to lead to an extended period of sub-par returns for the market, the Fed is unlikely to taper until 2014, and it will almost certainly take a gradualist approach once it does. Further, the scare of this past summer has given investors a chance to become used to the idea of tapering, meaning that future concerns are unlikely to hit the market as hard.

The takeaway is that even the rally of the past week may have taken the market too far in the short term, the outlook for the next six to twelve months is fairly positive. It’s true that investors who buy now expecting a repeat of the type of upside that occurred in the 2011-2012 are likely to come away disappointed, but a repeat of the spring meltdown appears equally improbable.

In short, investors could be looking at an extended period where traditional considerations — rather than Fed-speak and headlines out of Washington — are likely to be the key driver of performance. After the turbulence of the third quarter, most bond investors will take a quiet market as a reason to celebrate.

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

Article printed from InvestorPlace Media, https://investorplace.com/2013/10/4-reasons-safe-buy-bonds/.

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