How long can the bond rally continue?

[karluk]

Contrary to all expectations, bonds have rallied strongly since the start of the year. Long maturities have outperformed shorter maturities, and government bonds have outperformed corporate. If you had been fortunate enough to be heavily invested in long term government debt on January 1, you would, as of yesterday's market close, have more than a full year of yield just in asset price increases. Vanguard's two best performing bond funds are VUSTX (long-term treasury), up 4.90% YTD compared with a yield of 3.48%, and VLGSX (long-term government bond index), up 4.79% compared with a yield of 3.58%. It looks as if the rally will continue today, with the 10 year yield down an additional five basis points in early trading.

Note that this rally is not necessarily a reflection of the wisdom of piling a lot of money into long term debt. VUSTX and VLGSX are both still down since the beginning of 2013, even including the recent rally. However, it does show that bond prices are awfully unpredictable and that even the most despised asset classes can offer opportunities to investors who aren't scared away by all the negative press.

 

[Spanky]

no one knows with any degree of certainty. Many believe that interest will rise by year ends.

 

[REWahoo]

Many believe that interest will rise by year ends.

And have been saying that for the past five years. One of these years they'll be right!

 

[Spanky]

And have been saying that for the past five years. One of these years they'll be right!

Yea. In the interim, people who are cautious have been putting their money into CDs, stable value, and short-term bonds. Some may even increase exposure to equity.

 

[Loving Life]

With all the government debt, it will remain low for years so they can afford to pay the interest

 

[karluk]

Here is an article by Chuck Jaffe acknowledging the big rally in bonds. It's the first article I've seen on the subject. The contrarian in my is suddenly convinced that as soon as the "experts" and financial reporters start to take notice of a trend, the trend is most likely near its end.

As the investing world headed into January, it was almost universally accepted that 2014 would be a bad year to own bonds and bond funds.

As the investing universe begins February, it seems that everything has changed.

Suddenly, bonds are the hot investment, the thing the experts are saying to buy. Fears of a bond bubble—a collapse that was supposed to occur the instant interest rates started to rise—have dissipated, and investors who were being told to give up their bond funds are now being told to circle back for more.

Bonds are suddenly the hot investment - Chuck Jaffe - MarketWatch

 

[eytonxav]

What it does show is the importance of having bonds as a ballast in ones portfolio.

 

[karluk]

What it does show is the importance of having bonds as a ballast in ones portfolio.

I definitely agree with this sentiment. I think most members of this forum would agree as well. But I am tempted to make another conclusion that will probably be more controversial - investors made a huge mistake last year by reacting to the decline in bond prices by shortening duration and moving to cash. Anyone doing so has sold longer maturity bonds at a low point and has failed to benefit from the rally. Short term bonds haven't moved much at all this year. One needed to have some intermediate and longer maturities to see a bounce in prices.

 

[karluk]

And by extrapolation, investors who did stay the course last year and have now benefited from this unexpected rally, should now seriously consider rebalancing out of bonds. Simple arithmetic shows that a rally that has netted investors over a year's worth of yield in a single month can't continue indefinitely.

 

[jebmke]

What it does show is the importance of having bonds as a ballast in ones portfolio.

Yes. In 2008 there was a lot of drum beating about holding large amounts of cash. Cash has been a disaster.

 

[audreyh1]

I definitely agree with this sentiment. I think most members of this forum would agree as well. But I am tempted to make another conclusion that will probably be more controversial - investors made a huge mistake last year by reacting to the decline in bond prices by shortening duration and moving to cash. Anyone doing so has sold longer maturity bonds at a low point and has failed to benefit from the rally. Short term bonds haven't moved much at all this year. One needed to have some intermediate and longer maturities to see a bounce in prices.

I don't believe long-term bonds provide much benefit to an asset allocation. When I studied different asset allocations from Frank Armstrong's papers he demonstrated this pretty easily. Intermediate are OK.

I don't think investors will be punished for moving to cash NOW, but I don't think short-term bond funds at the current super low short-term rates and steep interest rate curve hold any protection - they are the most overvalued section IMO. I can easily see a scenario where short term interest rates rise, but intermediate and long-term interest rates don't move much if at all. It has happened before at the beginning of a tightening cycle.

Pundits keep saying "interest rates can only go up from here", but they are ignoring Japan scenario and ignoring that the US can go into another recession since we don't have a particularly strong economy at the moment.

 

[karluk]

I don't believe long-term bonds provide much benefit to an asset allocation. When I studied different asset allocations from Frank Armstrong's papers he demonstrated this pretty easily. Intermediate are OK.

I have read the same thing. In particular, I once saw an interview with last year's Nobel laureate, Eugene Fama, where he made the point that relatively short maturities (I forget exactly how short) capture about 80-90% of the diversification benefit of bonds.

I can think of reasons to own long maturities that go beyond their diversification benefit, though. One frequently mentioned alternative to stocks for funding retirement is to construct a bond or TIPS ladder. If you did that, you would presumably own some bonds or TIPS that mature each year for the anticipated length of your retirement. That could easily be enough justification for investors to buy 30 year maturities.

 

[karluk]

Just for the record, VUSTX and VLGSX were both up over 7% YTD at their high point on February 3. They both declined yesterday and appear to be headed for another decline today. So it would have taken perfect timing, but it was possible to squeeze a full two years' worth of yield in profits from these two funds by holding them for only a month + three days.

 

[bjorn2bwild]

Hoisington/ Hunt have been making a pretty convincing argument for a protracted period of low bond yields based on high, nonproductive private/public debt levels and ageing populations in the developed world.

http://hoisingtonmgt.com/pdf/HIM2013Q4NP.pdf

 

[karluk]

Hoisington/ Hunt have been making a pretty convincing argument for a protracted period of low bond yields based on high, nonproductive private/public debt levels and ageing populations in the developed world.

http://hoisingtonmgt.com/pdf/HIM2013Q4NP.pdf

Thanks for the article. I skimmed it and will read it more thoroughly later.

I had already noted an important point from the article - that long term bond yields have clearly risen to offer positive inflation-adjusted yields. At least the yields are positive for a typical range of inflation expectations, though not for a worst-case inflation scenario.

That's true of long term treasuries, and even more so of long term corporates. It was fairly easy to find long term corporates with yields in the 5% range, at least before the recent bond rally. Yields may be lower now.

 

[gcgang]

How long can the bond rally go on? At 3.5% yield 30 year Treasury, I'd say no more than 3.5%.

 

[Options]

As long as it will. And then it won't.

The quote from the Chuck Jaffe article is particularly disturbing and exemplary of The Business of Investing:

"...it was almost universally accepted...it seems that things have changed...suddenly...the thing the experts are saying...fears...investors who were being told...are now being told to circle back..."

I'm sorry, I can't believe people actually follow this swill.

Since before the inception of the stock market, history has rhymed again and again: (1) change in social mores from values of thrift/conservatism to excess (the current environment); (2) a laissez-faire approach to business and banking (current non-existent regulation of Wall Street); (3) corruption of government (current revolving door between Wall Street, government, K street). Time and again, these conditions have never ended well for the individual investor. Listening to and guessing a market's short-term direction is speculation, and has for the past several hundred years destroyed some of humanity's wisest men.

 

[semi55]

depends on terms

Yes, the 30 yr bond price has gone up - it's been in the tank for most of 2013, at recent historic lows, it had to go somewhere when the equity market moved down. There is still a flight to safety response in a lot of people. Long term rates aren't as affected by the unwinding of QE.

Overall, shorter durations should present better yield until the unwind is over.

 

[jon-nyc]

With my luck it'll last just until the auction of the 30yr TIPs then go back down again.

 

[karluk]

February is over and it has turned out to be a flat month for bonds. Bond prices peaked on February 3 and then turned south for much of the month, only to rally in the last week and finish near their highs for the year.

Long term government bonds are still ahead YTD, but long term corporate bonds have narrowed the gap. I find this interesting but have no idea whether it's a trend or just random variations in the price movements. VUSTX and VLGSX are both slightly below their February 3 highs, whereas VWETX is currently at its high for the year.

Vanguard Long-Term Treasury Fun Fund Chart - Yahoo! Finance