What To Do If Bond Yields Fall Rather Than Rise

Some experts expect bond prices to rise on deflationary pressure

When the world’s largest asset manager says benchmark bond yields could fall below 2%, fixed income investors would do well to pay attention. After all, if the bond bubble isn’t going to burst soon, it might be time to allocate more to the asset class for the price gains alone.

corporate bond yieldsThe conventional wisdom is that bond yields will rise now that the Federal Reserve repealed its bond-buying program, known as quantitative easing, and signaled a short-term rate hike in 2015.

But BlackRock, Inc. (BLK) expects bond prices to rise in the coming months, pressuring yields once again. Indeed, it’s possible that the yield on the benchmark 10-year Treasury note could dip below 2%, something usually associated with economic weakness, if not outright recession.

The key is what central bankers do outside of the United States. Japan is back in recession. By some measure, the Eurozone has entered a triple-dip recession. Monetary policy intended to jump-start those economies could drag down bond yields, and thanks to deflationary pressures, central banks have more room to work with than in years past.

With Japan in particular relying on unconventional measures — and oil prices fueling deflation — bond yields are poised to trade in a narrow range of 2% to 2.5%, BlackRock says. And before year-end, the 10-year Treasury could even fall below 2% as insurance companies shore up their portfolios. As BlackRock CEO Larry Fink said on CNBC:

“Most insurance companies were predicting higher rates. They had a portfolio that was short their liability. I believe the gap has widened.”

Deflationary pressures from oil prices could also keep the Fed from raising rates as soon — or by as much — as the market expects. That, too, would keep a lid on bond yields.

Bond kind Jeffrey Gundlach also expects bond yields to fall, albeit for different reasons. In a nutshell, Gundlach thinks a rate hike will choke off the all-too-mild recovery, sending investors back into the relative safety of bonds.

Play Bond Yields With Short-Term Issues

Either way, it’s pretty easy for fixed-income investors to prepare themselves for both lower yields while maintaining the liquidity needed to bail out if rates suddenly turn against them. The answer is to play bonds through exchange-traded funds.

Shorter term bonds are less susceptible to a selloff amid a rate hike, but they offer puny yields as well. However, this is more about generating return on a price basis rather than income from bonds. Heck, even the longest-term government debt throws off only 3%.

All bond ETFs should gain in price if bond yields turn lower, and although short-term bonds offer less potential for price appreciation than long-term issues, protection against a backup in yields is important. After all, it’s as tough to time the bond market as it is the stock market.

Two of the best short-term bond ETFs are the Vanguard Short-Term Bond ETF (BSV) and the Schwab Short-Term U.S. Treasury ETF (SCHO). BSV hold bonds with an average effective duration of  just 2.69 years, according to fund-tracker Morningstar. SCHO is even father along on the left side of the yield curve. Its portfolio consists of bonds with an average effective duration of 1.93 years.

True, the yields on BSV and SCHO are paltry — 0.96% and 0.37%, respectively — but then these are more about a balance of price appreciation and risk than income. Perhaps best of all are how inexpensive these ETFs are. The expense ratio on BSV comes to 0.1%, while SCHO costs a bargain-basement 0.08%.

Bottom Line

Either way, bond yields could easily defy expectations and fall — perhaps sharply — in the near and medium term. If that comes to pass, fixed income investors will be happy to hold short-term bond funds almost regardless of the expense.

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

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Article printed from InvestorPlace Media, https://investorplace.com/2014/12/bond-yields-fall-rather-rise/.

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