Based on the title of this post, you're probably thinking I'm going to talk about this year's market, or maybe the market over the past three years since the financial crisis. Wrong.
I'm talking about the market over the past 30 years (through Sept 30).
And really, it's two markets in combination that have produced such a unique outcome. The stock market has played a role, but really it's been a once-in-a-lifetime bond market that's driven the unique circumstances.
The biggest bond gains in almost a decade have pushed returns on Treasuries above stocks over the past 30 years, the first time that’s happened since before the Civil War.
Long-term government bonds have gained 11.5 percent a year on average over the past three decades, beating the 10.8 percent increase in the S&P 500, said Jim Bianco, president of Bianco Research in Chicago.
Amazing, particularly in light of how awesome the 1982-1999 stock market run appeared at the time. Of course, nobody knew stocks would stall for the next 12 years while the bond rally would continue to boom.
So what are the chances this could happen again? Pretty slim. As Bill Gross says:
“The rally in bonds is a once in a millennium event, but it’s absolutely mathematically impossible for bonds to get any kind of returns like this going forward whereas stock returns can repeat themselves, and are likely to outperform,” he said. “If you missed the rally in bonds, well, then that’s it.”
And that makes sense. Long-term bonds were able to eek out a victory over stocks based on the fact that interest rates fell from the mid-teens to low single digits during this period. Given that bond values rise as interest rates fall, that produced huge gains for bonds. But it's mathematically impossible to repeat unless bond yields were to once again start at very high levels.
At a big investing conference last week in Chicago, PIMCO chief Bill Gross made a compelling case that Treasury yields have fallen so low that it's difficult to see how they'll earn much for investors over the next few years — especially if inflation levels that many expect come to fruition. (PIMCO runs the world's largest bond fund, PIMCO Total Return.)
Gross's comments brought to mind an article I'd read a month ago, but hadn't commented on. Provocatively titled, Holding TIPS Will Make You Poorer, author Brett Arends painted an extremely grim outlook for short-term TIPS bonds.
First, a quick refresher for those who aren't clear on exactly what TIPS (Treasury Inflation-Protected Securities) are or how they work.
TIPS are inflation-protected versions of U.S. treasury bonds. They pay a lower yield than a regular Treasury bond of the same length, but also pay the owner the official rate of inflation during that time.
So, for example, if a 10-year Treasury was yielding 3.0%, a 10-year TIPS bond might yield around 1.2% at a time when official CPI inflation was running 1.6%. That TIPS owner would expect to earn the 1.2% base yield plus the 1.6% inflation yield, for a total of 2.8%. The relationships are never exactly precise, which reflects the bond market's fear (or lack thereof) of future inflation at the moment.
Back to Arends' column. His point was that with real (after-inflation) yields on short-term TIPS having gone negative (investors would earn the inflation rate minus a small amount), these short-term TIPS were almost sure to be losers going forward.
Ironically, after pulling that article up last week in order to comment on it, I came across a new column by the same author. This column's subtitle is Some TIPS Bonds May Still Offer a Decent Deal. Now this may seem double-minded and unstable in all his ways, but it's really not. (Arends is actually one of my favorite columnists because he consistently makes interesting and well-reasoned points.)
The summary of this latest column is that while short-term TIPS look like a bad deal due to their incredibly low interest rates (especially if rates are set to rise, as Gross contends), longer-term TIPS don't look so bad. In fact, when you factor in that they protect against inflation on the one hand, and deflation on the other (via the Treasury promising to pay back at least their face value at maturity), they hold some particular appeal at a moment in time when inflation still seems like a distinct possibility, yet softening economic indicators have reawakened deflationary fears that another recession could be looming.
It's worth noting that both of Arends' columns seem to assume that investors will buy and hold individual TIPS bonds until maturity. That's not likely the case with most SMI readers, who are more likely to own TIPS through a mutual fund. The Gross/Arends arguments also seem to assume an investment time frame of at least the next several years. They are primarily arguing that buyers of these bonds today are going to get hurt as they hold them over the next several years.
It's worth noting that while people have been negative on Treasuries for quite a while, Treasuries have continued to defy expectations and rally this year. So have TIPS. In fact, while many would have said at the beginning of the year that Treasuries/TIPS have nowhere to go but down, a Vanguard fund focused on TIPS is already up 5.02% year-to-date. That's a healthy full-year return earned in less than half a year. Now it's entirely possible that entire gain could evaporate over the next six months — we certainly don't know what the future holds. The point is simply that the length of the current Treasury rally has already surprised most experts, making it difficult to predict how long it may last.
In summary, TIPS still have some appeal. But given their current valuations and today's extremely low interest rates, along other external factors (debt-ceiling impasse, end of the Fed's QE2 policy), that appeal appears to be significantly lower than usual.
After receiving a few questions in response to yesterday's bond-related post, I thought it might be helpful to offer some additional thoughts here today.
There's quite a bit we can learn from recent activity in the bond market, so let's start there with a few specifics.
Over the past three months, the 10-year Treasury yield has gone up by 1%, from 2.65% on November 10 to 3.66% yesterday. That's a very significant rise in a short period of time.
Bond Investing 101 (as summarized in our current article, The Bond Basics You Need to Know in 2011) tells us that when bond yields rise, their prices fall. This is indeed what we've seen. The degree of the price decline depends primarily on the length of the bond. The longer the maturity, the greater the price decline.
We can see this clearly in the returns of various bond funds over the past three months. Vanguard's Intermediate-Term Bond Index fund has lost -5.73% over the past three months, while the company's Short-Term Bond Index is down just -1.56%. (This is a vivid illustration why we encouraged our readers to shorten their bond maturities in anticipation of rising interest rates.)
What about TIPS? TIPS are "inflation-protected" bonds that are supposed to adjust to keep up with inflation. But this doesn't mean that they can't go down in value. There are two basic forces at work with TIPS.
First, they do in fact respond to increases in CPI-measured inflation, helping their owners maintain their purchasing power in inflationary times. Unfortunately, the second force is old fashioned supply and demand. As investors see higher interest rates coming (or think they do, at least), TIPS are subject to the same selling pressure as regular bonds. So while TIPS help insure bond portfolios against rising inflation, they're still subject to swings in interest rates.
Back to the overall bond landscape. The 1% rise in rates over the past three months is quite steep. It's not typical for bonds to move that far, that fast. At this recent pace, the 10-year Treasury bond would be yielding 7.65% a year from now, up from 3.66% today. I'm not aware of anyone who expects that to be the case.
In fact, it's important to recognize that while the higher yields of the past three months have bond investors spooked, the 10-year Treasury note has almost exactly the same yield now as it did one year ago!
On February 9, 2010, the yield was 3.67%. Yesterday, it was 3.66% (see chart at left). So this recent rise in interest rates has simply offset the significant drop that occurred as investors poured money into bond funds last year.
The main takeaway is not to get overly worked up about short-term changes in bond yields (and by extension, losses in bond funds). We don't want to be blind to the larger trends, which is why we have suggested shifting bond money to the short-end of the yield spectrum. But these swings in interest rates happen, and usually they don't signify a whole lot.
Further, all it would likely take to reverse the upward move in bond yields is for Europe to announce a new round of trouble. That, or a dozen other catalysts, could easily prompt investors who've been cautiously pulling their money out of bonds and putting it into stocks to reverse course, sending bond yields lower again.
In contrast, if you're following SMI's approach and investing based on a long-term, personalized investing plan, you don't need to sweat every little blip in your bond returns (just as you shouldn't sweat every little blip in your stock returns). Hopefully this helps explain how you can keep an eye on some of these trends without becoming overly concerned about them.
The primary purpose of having bonds in your portfolio is stability. Price appreciation comes on the stock side. Bond holdings, in contrast, decrease portfolio volatility. "Bond ballast" helps keep you from abandoning the markets in fear during times of maximum market stress.
This isn't the only way to approach investing, of course, but it's how we approach it at SMI. In our strategies, we don't reduce our bond holdings simply because some people think bond prices are vulnerable. They may be, but even in such circumstances, bond portfolios — if properly positioned — are still going to be less "risky" than stock holdings in terms of their vulnerability to big losses. So don't throw your ballast away just because it looks less stable than it did a year ago. It's still going to help keep your emotional boat from tipping over in a crisis.
So, just to be clear, we're not encouraging anyone to reduce his or her bond holdings as a result of the information presented below. Our approach is to deal with an increase in bond risk by shifting toward the short-end of the yield curve, not by reducing bond holdings (if indeed, bonds are present part of your long-term plan).
On to current events. The chart below shows the yield of the 30-year Treasury bond over the past 24 years (this chart was published recently in the Los Angeles Times). It shows the fairly steep rise in yield from a panic low of 2.5% in January 2009 to the recent 4.70% yield.
As you can see, there have been plenty of ups and downs over the past two decades, but the steady trend has been toward lower yields. As this month's SMI cover article points out (The Bond Basics You Need to Know in 2011), lower yields mean higher bond prices. In other words, we've had a huge bull market in bonds as a result of these falling yields.
But, as the chart vividly shows, that downward trend line has been in jeopardy lately. In fact, the 30-year Treasury bond ended last Friday with a yield of 4.732%, effectively crossing that long-term trend line for the first time in many years. These "technical" trends aren't gospel, but there's no way to paint this as anything other than a potentially ominous sign. (See my October 2009 article, Re-Evaluating the "Safe" Part of Your Portfolio.)
That said, the end of a falling trend in interest rates is not necessarily the same thing as a new rising trend. Bond guru Bill Gross of PIMCO, while warning many times over the past year that the end of the bond bull market is near, has also said that he doesn't anticipate Treasury yields to rise rapidly (he expects a gradual rise).
A couple of weeks ago, I raised the question of whether bonds were looking bubbly. A day later, Bespoke Investment Group published a pair of charts that add another angle to that discussion.
Bespoke's first chart shows that in absolute terms, the rate on 10-year Treasuries is indeed at historical lows (surpassed only during the worst of the financial panic a couple years ago).
However, as we've written before regarding fixed-income yields, the most important number isn't necessarily the apparent yield you earn, it's your net "real" return after inflation is factored in. And on that score, today's inflation-adjusted yields — while below average — are nowhere near the extremes we've seen at other junctures.
These charts don't answer the "bond bubble" question, but they do indicate that when the full economic picture is taken into consideration, current bond yields don't seem that crazy. Bottom-line: if our economy truly is "going Japanese" — i.e., several years of deflation, or at least no real return of inflation — current bond prices may not be inappropriate at all.
The question, of course, is how likely is that deflationary outcome? (Here's a rather technical analysis that concludes the bond market is pricing in a 70% probability of this type of Japanese deflationary outcome.)
That's the question being raised (and answered) by Chris Davis, head of the Davis Funds. He says the answer is "yes" (Marketwatch has the story).
Davis (left) thinks bonds may be okay over the next year or two — the bond bubble (as he sees it) could last another couple years. But he thinks stocks are a safer haven when looking out over the next decade.
It's a significant warning — and not an unfamiliar one for SMI readers. We've been beating the "Bonds-are-starting-to-look-scary, given-that-they're-the-supposedly-safe-part-of-your-portfolio" drum for a while now.
Who is Chris Davis and why should we care what he thinks? Here's how MarketWatch describes him:
While Davis may not be a household name to many investors, he represents a long and storied brand in the fund business, a third-generation fund manager whose firm runs $65 billion in assets, and whose management acumen is widely hailed as being a model of sound thinking.
That doesn't necessarily mean Davis is right. But he adds another angle to the theme we've been warning about for a while now, which makes the Marketwatch article worth a quick read.
Citing stats from the Investment Company Institute, USA Todayreports that investors withdrew a net $490 billion from money market funds during the first 10 months of 2009. Most of went — where?
If you guessed "into stock funds," you're wrong. Nearly two-thirds of the money went into bond funds.
Normally, investors chase after stocks during periods of red-hot returns, and this year has produced rip-snorting returns for many stock funds. The average stock fund has soared 27.4% this year, according to Lipper, which tracks the funds. And 36 funds have soared 100% or more in 2009.... But investors aren't chasing hot returns.
Instead, they're "chasing" the perceived safety of bonds. Plus a significant number of investors apparently are cashing out and using the money for "non-investing" purposes.
"More money is flowing out of money funds than is going into bond funds — something that's only happened twice in 26 years," says Vincent Deluard, strategist at TrimTabs.com, which tracks fund flows. "It shows how deep the recession is: They may be taking money out to pay the bills or the mortgage."
Unfortunately, the story doesn't break down — for the dollars going into bonds — just how that money is being spread among funds of different average durations. Given current low rates, short- and intermediate-term funds would seem to be the safest bond funds to be holding now. People buying into funds with long durations may be setting themselves up for a major disappointment.
Bond prices typically rally when interest rates fall and tumble when interest rates rise. The yield on the bellwether 10-year Treasury note is just 3.54%. "If rates rise, that would be bad," Deluard says.
Indeed, as we warned in the January issue of SMI, the "potential for rising inflation to hurt bond values by pushing interest rates higher is one of the more important big-picture ideas for investors to be mindful of going into the next decade."
The Wall Street Journal has also taken note of the heavy inflow into bond funds, speculating that the shift from stocks to bonds is influenced by the fact that "[b]aby boomers...are bulking up on bond funds as they approach retirement."
In November, only three of the 20 best-selling funds were diversified U.S.-stock funds (one index mutual fund, two index ETFs).
Blog
First, a quick refresher for those who aren't clear on exactly what TIPS (Treasury Inflation-Protected Securities) are or how they work.
Here's another short audio commentary from SMI founder and publisher 
On February 9, 2010, the yield was 3.67%. Yesterday, it was 3.66% (see chart at left). So this recent rise in interest rates has simply offset the significant drop that occurred as investors poured money into bond funds last year.
Davis (left) thinks bonds may be okay over the next year or two — the bond bubble (as he sees it) could last another couple years. But he thinks stocks are a safer haven when looking out over the next decade. 