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Forget the Fed: 6 Reasons to Hold on to Your Bond Funds

All signs point to a continuation of low yields

Whatever happened to that bond bear market?

In December 2013, 10-year U.S. Treasury yields hit a peak of 3.03% and the consensus view was that rates “had nowhere to go but up” in 2014. That widely held view proved well off the mark, of course, and today the 10-year is trading below 2% (reflecting a rise in its price).

Nevertheless, talk persists that bonds are a dangerous investment that are due for a correction.

This might be worrisome to the type of conservative investors who typically own bonds and bond funds, but the reality is that yields continue to face meaningful downward pressure and are likely to stay low for quite some time.

In fact, there are six reasons why diversified fixed-income portfolios can continue to work.

U.S. Federal Reserve Policy Is a Nonissue

The primary concern for the bond market has been the question of what happens once the Fed begins to tighten. Despite all of the media attention lavished on changes in Fed policy, bond investors can throw this consideration out the window for now. The Fed has made it perfectly clear that it is being very cautious in raising rates, and rates are likely to stay extremely low for a very long time even if the central bank enacts it first hike in the next few months.

Further, it’s evident that the Fed is taking great pains to avoid surprising the markets — and it’s surprises, of course, that drive major moves. With rate hikes likely to be slow and well-telegraphed, an increase in the fed funds rate to 1% by September 2016 — the current view of the fed futures markets — is unlikely to put upward pressure on intermediate- to longer-term bond yields.

U.S. bonds: The Best House in a Bad Neighborhood

One of the primary factors helping the U.S. bond market is that weak overseas growth has caused bond yields overseas to fall even lower than those here in the United States. This table from the Financial Times illustrates the yield gap of the U.S. 10-year note relative to 19 major global developed debt markets. U.S. Treasuries are out-yielding 16 of the 19 countries, with exceptionally large gaps relative to the key markets of Germany and Japan. Unless growth suddenly accelerates overseas, which appears highly improbable, the U.S. market can continue to attract assets by virtue of its high relative yields.

Inflation a Nonfactor

Will bond prices experience a meaningful correction when inflation is absent? That’s a question bond bears should be asking, given that U.S. inflation is low and falling (as shown here).

With plenty of slack in the labor markets, capacity utilization having declined for four straight months and severe weakness in the commodity markets, the odds are extremely low that we’ll see the type of inflation uptick that would influence either Fed policy or bond market performance.

This is especially true given the extremely weak inflation in the overseas developed markets, which is clearly being exported to our shores.

Competition From Equities Has Lessened

Several years ago, the concept of the “great rotation” emerged onto the investing scene. The idea, at the time, was that the potential for rising rates would lead to massive flows out of bonds and into equities. As it turned out, this view was only half right — while stocks indeed have seen tremendous inflows, bonds haven’t suffered a corresponding outflow.

Today, U.S. stocks are even less likely to draw assets from the bond market because valuations are well above historical norms across the market-cap spectrum. In addition, the earnings yield of the S&P 500 Index, at 5.03%, is well off of its 7.69% level of Sept. 30, 2011 — a day on which the 10-year Treasury closed with a yield of 1.92%, roughly where it stands today. (Earnings yield is a measure of earnings divided by stock price, or the inverse of the P/E ratio).

While the predictive value of this metric is unreliable, to be sure, it nonetheless shows that bonds have become increasingly competitive with stocks even with yields staying at ultra-low levels.

The only game in town when bad news hits

The markets have gone so long without major bad news that it’s easy to forget the extent to which Treasuries can benefit from “flight to quality” rallies. Bonds have managed to hold their ground in the past year-plus with virtually no help on this front. As a result, assuming that yields climb meaningfully from here also assumes that headline risk will remain a non-factor indefinitely — which of course won’t be the case.

What’s more, U.S. Treasuries are an even more attractive source of safety now than in the past due to their meaningful yield advantage vs. the developed markets (not to mention the fact that gold hasn’t been able to get out of its own way in nearly three years). The slightest whiff of adversity in the financial markets would be a boon for Treasuries, perhaps even driving yields back down to the 1.6% level that has acted as support since the autumn of 2011.

10-Year Treasury Yield, 3-Year Chart

The Lessons of History

Together, these factors have put enormous downward pressure on U.S bond yields, and that doesn’t look set to change in the near future. Bonds certainly aren’t going to make anyone rich at this point, but the likelihood of a severe downturn is very small given the extent of pent-up demand from global investors. It’s therefore necessary to avoid reading too much into the types of periodic, short-term spikes in bond yields such as the one that occurred during February and the first week of this month. Further, two lessons from the past argue against the idea of a severe down market in bonds.

First, it’s important to remember that the potential downside in bonds has been relatively limited in even the worst markets. The Barclays Aggregate Bond Index — the index tracked by the Vanguard Total Bond Market ETF (NYSEARCA:BND) and its mutual fund counterpart, the Vanguard Total Bond Market Index Fund (MUTF:VBFMX) — has had only three down years since 1980. In each case, the losses were limited: -2.92% in 1994, -2.02% in 2013, and -0.82% in 1999. Bond investors never like to experience principal drawdowns, of course, but it’s worth considering whether potential losses of this magnitude truly call for a strategy shift.

The second lesson comes from Japan, where the notion of “yields are so low they can only go up” was put to rest years ago. The country has never been able to emerge from its post-crisis spiral of slow growth no matter how aggressive the actions of its central bank, which indicates that yields can remain depressed far longer investors might expect.

Japanese Government Bonds, 1984-present

Bottom Line

Until there’s a meaningful change in the big picture, the U.S. bond market looks set to provide low but steady returns. Fixed-income investors should keep a steady hand and avoid the temptation to shift their portfolio’s risk profile in an effort to avoid a bear market that may never come.

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

Article printed from InvestorPlace Media,

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