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Five Reasons It's Time To Buy Bonds Again

Dec 20 2013, 5:51pm CST | by

Five Reasons It's Time To Buy Bonds Again
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Bonds in 2013 finally got their comeuppance. After a long, pleasing ride of income + price gains, the bond market decided the party was over. It only took four months for the 10-year U.S. Treasury note to drop the equivalent of over five years’ interest. All but the shortest maturities suffered similar fates.

So why should we expect that we’re safe again? Couldn’t 2013’s drop be the harbinger of worse to come? Like gold, mightn’t we be entering a secular bear market in bonds?

Here are the five reasons why bonds can be bought now with confidence and safety:

1. The bond market is the premiere measure of what’s to come

Unlike with stocks, professional bond investors are notorious for keeping an unbiased, critical eye on what’s happening – particularly what could go wrong. The reason is that bonds have a skewed return outcome – the expected and maximum return over a bond’s life are the same. Buy a bond with a 3% yield-to-maturity and hold it to maturity – if all goes well, the return is 3%. However, let something go awry and that return is in jeopardy.

What this means is that, at any point in time, what you see is what to expect. Unlike with stocks (or gold), where previously bullish investors still hanging on could cause a further drop in price if spooked, bond investors adjust quickly to new facts and forecasts, resetting yields that fully reflect the changed environment.

2. The Fed’s effect on longer yields is over and done

Yes, the Fed says they’re only reducing their purchases slightly. However, their effect on non-short yields has always been tenuous. Past periods have shown that effectiveness, unlike with money market rates, can be close to zero. Judging by the size of the 2013 yield adjustments, the Fed effect has mostly or completely dissipated. We can see the effect by looking at the new steepness in the yield curve. Anchored in the Fed’s near-zero short-term rates, longer yields are significantly higher. In absolute terms, the new yields look appropriate to current economic/financial conditions and inflation outlook.

Want some proof? On Tuesday (12/17), before the Fed’s Wednesday release, The Wall Street Journal (in “Ahead of the Tape”) reported, “Bonds Not Shaken or Stirred by Fed Meeting.” Explaining, “… there is an argument to be made that it [the bond market] already has priced in the scaling back of bond purchases.”

The important explanation for our use is, “The yield on the 10-year Treasury note has risen 1.25 percentage points, to 2.877%, since taper talk began in early May. It may not go much beyond 3% for the time being.” Sure enough, the Fed’s Wednesday comments failed to bump yields. The stock market, happy at the bond market’s steadiness, galloped ahead, in spite of the Fed’s “we’ll be cutting back” indication. Here’s the U.S. Treasury yield picture for 2013 to date:

3. Economic measures across the board are strong and trending upwards

The past few weeks have been filled with virtually all reports being significantly positive and showing that growth has taken hold. Most importantly, this growth finally is having the natural compound effect of raising valuations, confidence and even government revenues.

For bond investors, this underlying economic health is just the thing to promote financial health and a sound bond market.

4. Bondholders now have added protection as a result of the Great Recession and financial stress

It isn’t just the new regulations and enhanced regulatory watchfulness. Nor is it the more reliable bond ratings. While those items are important, the real protection comes from Wall Street, itself. Having been through such an undesirable period, business operations are both well founded and sensible. No industry-wide bubbles, over-optimism or extremism exists now. (Yes, something will happen in the future, but that’s far off.)

Therefore, we can rest assured that bonds and well-managed bond funds don’t have hidden risks or unrealistic expectations underlying their valuations.

5. The steeper yield curve provides added return potential and safety

“Riding the yield curve” can be enjoyable, offering gains and protection from interest rate increases. For example, take a 10-year bond bought at a 3% yield, when 9-year bonds are at 2.9% yield. If nothing changes after a year, the bondholder has the 3% income plus the price increase that adjusts the bond to the 2.9% yield. Conversely, if rates have risen such that 9-year bonds now yield 3%, the bondholder has the 3% income without any price loss.

The graph below shows the yield spreads between a range of U.S. Treasury constant maturities: 20-year, 10-year, 5-year, 3-year, and 1-year. Note that, because the 1-year barely budged, the moves by the other maturity bonds opened the spreads (i.e., steepened the yield curve).

The bottom line

The bond market is back to its premiere role in the U.S. financial system. Now untethered from the Fed’s machinations and supported by a stronger and growing economy, it is fully operating as the provider of sensible borrower financing and reasonable investor returns. The past economic/financial turmoil has produced protections for bondholders, so we can have confidence in our investments. As a bonus, the Fed’s continuing program of near-zero short-term rates, combined with the now unfettered longer-term rates, has created a bondholder-friendly, steep yield curve.

Therefore, now is a good time to buy bonds.

Source: Forbes

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