Bonds get no respect

John Osbon - June 5, 2012

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.

If 10-year yields rise to:

Total Return (1 year)

2 percent

-2.07%

3 percent

-9.63%

4 percent

-16.53%

5 percent

-24.32%

 

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.

 

For our most popular posts, click here.



This article may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.

Nothing in this article is intended to be or should be construed as individualized investment advice. All content is of a general nature. Individual investors should consult their investment adviser, accountant, and/or attorney for specifically tailored advice.

Any references to third-party data or opinions are listed for informational purposes only and have not been verified for accuracy by the Adviser. Adviser does not endorse the statements, services or performance of any third-party vendor without specifically assessing the suitability of a third-party to a client’s or a prospective client’s needs and objectives.

All data from Bloomberg.

 

 

 

 

 

Print Friendly, PDF & Email

Disclaimer

  • This communication may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.”
  • “Historical performance is not indicative of future results. The investment return will fluctuate with market conditions.
  • Past performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor.
  • Investment strategies, philosophies, allocations and holdings are subject to change without prior notice.
  • This communication is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice.
  • While the Adviser believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.
  • Adviser does not endorse the statements, services or performance of any third-party vendor.
  • Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Adviser’s clients may or may not hold the securities discussed in their portfolios. Adviser makes no representations that any of the securities discussed have been or will be profitable.