Bonds get no respect

Last week was remarkably good for many investors, but you’d never know it from the headlines. While big losses in the equity market got all the attention, bond prices surged.  Bond reached new highs last week as investors couldn’t seem to get enough US 10-year Treasury bonds. The yield on that bond dropped below 1.5 percent, an all-time low since records were kept in 1946.

Anyone who lends our country money for 10 years at 1.5 percent should be welcomed and thanked, in my view.  But can those investors make money?   The answer is a definitive: “Yes, but…”

Can you make money in bonds?

Many are holding profits in bonds now. For instance, one of our favorite ETFs, the iShares Barclays TIPS bond fund (TIP) has topped 120, its highest price since its debut on December 8, 2003 at 102.  In other words, anyone who bought TIP at any time in the last 8 years has a profit, not to mention its current yield of 3.7 percent, among the highest in all US government bonds.

Despite predictions of higher rates for several years now, the opposite has happened. But if you are buying Treasuries at current prices, you need interest rates to fall even farther to post a profit. Is that even possible?

Yes! Think Japan. If the US Treasury 10-year yield drops from the current 1.55 percent in the next year to Japan’s current 10 year yield of .82 percent, the US bond will return 7.94 percent for the year, including the 1.5 percent coupon.

Well, Japan has been an outlier for years. What about Europe? UK gilts fell to 1.43 percent, the lowest since the founding of the Bank of England in 1703 (and an interesting vote of confidence in time for the Queen’s Jubilee!). Denmark recently became the first EU country with a 10-year yield below one percent. Germany’s 2-year bond has a delightful negative yield (you get back less money than you invest), while its 10-year is at 1.12 percent.

Yes, but…

Yes, there’s money to be made if rates continue to fall. But it’s a two way street, and to many the other side of the street looks like it has more lanes. If rates rise, and they surely will someday, bonds will fall in value.

By how much? The relationship between yield and price is straightforward math. One can calculate precisely the price risk of owning the US 10-year Treasury. (It works for other bonds, too). Below is the price depreciation schedule over a one year time frame if 10-year  rates go up.

There’s clearly price risk in Treasuries at these historic low yields. How unusual is a yield of 1.5 percent?  This chart shows yield over the last 11 years.

The 10 year was at 5 percent as recently as July 2007, before the Great Recession.

Let’s be clear: We don’t know what will happen next in bond yields and prices. But given that rates are so low already, with so little room to fall farther, perhaps it’s now time to sell some of those bonds, or rebalance back to original allocations. My suggestion is to do the math first, before jumping to conclusions and acting without complete information.

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