Comment
Volume 1 of hyperventilation that the bond market was going to crash came last week.  This is a regular running theme we have highlighted for years. Wall Street’s best and brightest constantly warn that the bond market is the worst investment one could possibly make.  But, as the next chart shows, bonds continue to outperform stocks.

 

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http://www.arborresearch.com/bianco/SubscriberArea/newsclips/2013/01/trr0107131_big.gif

 
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It is important to note that bonds have outperformed stocks over the last few years because it shows that investors are not losing sleep in bonds as they are doing better than the stock market.  This is confirmed by the chart below which shows the weekly flows into bond funds (top panel in blue), domestic equity mutual funds (second panel in green), world equity funds (third panel in red) and hybrid funds (bottom panel in blue).  The data is current through Wednesday, December 26.

As of 10 days ago the public was showing no interest in moving out of the bond market and into the stock market.  This has been the case for several years.  Why should they? The bond market is the best performing option.

http://www.arborresearch.com/bianco/SubscriberArea/newsclips/2013/01/weeklymf0107131_big.gif

                     <Click on chart for larger image>

Now at some point the bond market will underperform the stock market.  When will that happen?  As we detailed in our December 7, 2012 conference call:

One, the buyer of Treasury securities has a printing press, and he is located in Washington, D.C., in the Marriner Eccles Building. That is the Federal Reserve. They buy $40 billion a month in mortgages, $45 billion a month of Treasuries. The dealer community is so afraid of the Federal Reserve’s open-ended buying that the dealer community no longer shorts the Market as a speculative trade.

We detailed the dealers’ hesitance to short Treasuries on December 4:

In a crude way, the amount or volume of “specials” in the repo market tells us something about the willingness of credit market dealers and speculators to short US treasuries. An elevated volume or number of special repo securities would indicate that there are a lot of short positions in the liquid markets. Conversely, a dearth of specials might indicate a lack of short US treasury positions.

The chart below is current through January 7 and it shows the dealers have still not borrowed Treasuries on special from the Federal Reserve since late July, save two days around a technical short in late October because of Hurricane Sandy.  Prior to 2008, it would be rare to see the dealers go an entire week with borrowing on special from the Federal Reserve.  Now they are approaching six months!

Until the Federal Reserve backs off its promise to buy bonds (which we do not believe is the case as we detailed last week) and the dealers are confident enough to short Treasuries, we would not look for a significant selloff.

http://www.arborresearch.com/bianco/SubscriberArea/newsclips/2013/01/specials0107131_big.gif

                                                              <Click on chart for larger image>

  • Business Insider – ART CASHIN: The End Of The Bond Bull Market Will Be Signaled By A Stampede
    Eric King:  “With the Fed increasing QE, and all of this money printing around the world, Art, what type of effects will we see in 2013?”
    Cashin:  “Well, there are a couple of things to look at.  For example, we are beginning to see rates move up.  Some of that was based on the FOMC minutes.  The thing that I will watch for is mortgage applications.  If the public begins to believe that the trend in rates has turned, that rates are heading higher, I believe you may begin to see a stampede of people trying to lock up those low mortgage rates. That will be a signal to me that the public is coming to believe that the great bond bull market is probably ending.  It will mean money coming out of bond funds.  So one of the key things I will be monitoring very carefully over the next month or two, is there new or explosive growth in mortgage applications?
  • The Sunday Times (UK) – End of bond craze may send shares soaring, say fund gurus
    A WALL of cash running to tens of billions of pounds could be about to flee from government bonds into the stock market, top investors have warned. Executives at Fidelity, Black Rock, Goldman Sachs Asset Management, GLG and other large fund managers have reported signs that investors may start to switch cash from highly priced “safe haven” assets into shares over the coming weeks. If the world’s big pension funds, insurance companies and sovereign wealth funds move even a tiny percentage of their portfolios out of bonds and into equities, it could spark a big rally in share prices. It would also prick the bubble in government bond prices that has let George Osborne, the chancellor, keep down the cost of servicing Britain’s giant debts. “There is some noise at least, and certainly investor inquiry, about a rotation from bonds into equities — at last, some might say,” said Jim O’Neill, chairman of Goldman Sachs Asset Management. O’Neill added that while there were not yet clear signs of an asset switch taking place, recent data has shown an increased appetite for equities.America’s politicians started a stock market rally last week after agreeing a deal to scale back tax rises and spending cuts that threatened to tip the US economy into recession. The agreement removed one of the big fears hanging over the stock market. As the equity rally began last week, the yield on Britain’s 10-year bonds crept above 2% for the first time since last May — indicating selling by investors.
  • Business Insider – GOLDMAN: Bond Market Investors Are About To Get Crushed
    Goldman Sachs strategists have issued a big warning to clients hiding out in bond funds: You’re about to lose your shirt. The reason: interest rates began rising this week, and if they return to the historical average yield of 3 percent, prices for long-term bonds will plummet. (By their very nature, fixed income prices must fall if rates rise.) “A reversion of risk premiums to historical averages of 6% nominal rates (3% real rates and 3% inflation) would suggest estimated losses in portfolios with bond durations of 5 years of 25% or more,” equity strategist Robert D. Boroujerdi said in a note.
  • CNN – Beware the bond bubble in 2013
    After three decades of declines, interest rates are near rock bottom, and many Wall Street experts think the bond bubble may be about to burst. In fact, nearly 40% of the 32 investment strategists and money managers surveyed by CNNMoney think that interest rates will begin to rise in 2013, and another 30% say the shift will begin in 2014. That would be even sooner than the Federal Reserve’s projections. The central bank doesn’t expect to raise the federal funds rate, the key interest rate that influences overall interest rates, until some time in 2015. The Fed said last month that it will keep its stimulative policies in place until the unemployment rate falls to 6.5%, which it doesn’t think will happen before then. “Like it’s been in the case of Japan, low interest rates can go on much longer than expected, but right now it seems that all the stars are aligned for interest rates to rise,” said Jeff Weniger, senior investment analyst at BMO Private Bank. “But ultimately, whether it happens in 2013, 2014 or 2015 doesn’t matter too much. What matters is that you’re not invested in bonds when they do rise.”

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  • The Wall Street Journal – Why Bond Funds Could Get Dicey This Year
    The start of 2013 shows that bond-fund investors need to be on their toes. It’s an outlook where it may pay for investors to be cautious, but not completely defensive.  That means paring back areas which have had big rallies in recent years, such as high-yield bond funds, which are up an average of 10.5% over the last three years, according to Morningstar. It also means beginning to trim bond funds that will take a big hit whenever interest rates finally rise.  However, money managers say it’s worth casting a more global net toward emerging-market bond funds.  Whatever the bond-fund strategy, yields are already extremely low across most major markets. That calls for a penny-pinching approach to mutual-fund fees. For most investors that means focusing on lower cost index-based strategies, such as exchange-traded funds.
  • Telegraph (UK) – Bond bubble fears and why I took the biggest bet of my life
    Last month I took the biggest bet of my life and, without wishing to overstate the downside, put 26 years’ savings at risk. Contrary to the conventional wisdom that people should raise their exposure to supposedly low-risk bonds and reduce shareholdings as they get older, I did the opposite and sold all the bonds in my company pension to buy shares. That might be regarded as a recklessly risky thing to do for several reasons. First, bonds – a form of IOU issued by countries and companies – provide investors with a promise to pay income and repay their capital at fixed dates in the future, whereas shares give no guarantees at all. Second, bonds have delivered higher total returns than shares for more than 20 years now. Third, bonds issued by the British Government, sometimes called gilts, are the basis of the annuities that most “defined contribution” or “money purchase” pensioners use to fund retirement. So what on earth possessed me to sell all my bonds and beef up exposure to shares? The short answer is that I expect bond prices to fall when interest rates rise and suspect that shares offer much better long-term value. One reason bonds beat shares over the past two decades is that interest rates have plunged, pushing up the relative attraction of the fixed income that most bonds promise to pay. But a trend is only a trend until it stops. Nearly four years after the Bank of England froze Bank Rate at 0.5pc there is precious little room left for further reductions and plenty of scope for rates to rise. If that happens, the apparent security that bonds provide could prove illusory.
  • Bloomberg.com – No New Normal as Stocks to Bonds Gain Like the Roaring ’90s
    Bill Gross and Mohamed El-Erian, the co-chief investment officers of the Newport Beach, California-based money management company that oversees $1.9 trillion, correctly foresaw that global expansion would remain sluggish. The world’s economy probably grew 2.2 percent last year, below the 3.2 percent average of the decade before the 2008 financial crisis, according to World Bank data compiled by Bloomberg. Pimco’s outlook, announced in 2009, was less accurate for financial assets as unprecedented stimulus by central banks drove up demand for stocks and bonds. Fixed-income securities around the world returned more than the average of the past 16 years in 2012 and the value of global equities increased by $6.5 trillion as the MSCI All-Country World Index rose 13.4 percent. “They’ve underestimated how big the policy response would be and what type of positive impact it would have on financial markets,” said Jay Schwister, a managing director and senior money manager in Milwaukee at Baird Advisors, which oversees $17 billion of bonds. “From the real economy standpoint, the new normal that Pimco forecast is pretty much playing out,” he said Jan. 3 in a telephone interview.

Category: Fixed Income/Interest Rates, Think Tank

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4 Responses to “Everyone Hates Bonds, 2013 Edition Volume 2”

  1. streeteye says:

    Charts are broken, but in 2012 SPY returned 16% vs. 4% for BND. The S&P dividend yield is higher than the 10-year Treasury yield.

    A 10-year bond bought at a yield of 1.8% will return, best case, 1.8% nominal over its lifetime (less in the event of default.) If the yield goes to zero this year, it will return 18% this year, and zero over the rest of its lifetime.

    So, the total returns of the past are mathematically unobtainable in the long run. When you take inflation into account, bonds aren’t a real return investment, they’re a hedge against deflation and a big drop in stocks.

    Barring recession and deflation, which the Fed has vowed to fight at all costs, even to the point of tolerating inflation, the long-run case against bonds is pretty airtight.

    In the short run, sure, calling for a bond crash is a fool’s game. But if you’re not cautious about bonds, you either think there’s going to be economic disaster, or you’re a momentum player counting on the greater fool theory.

  2. bonzo says:

    >But if you’re not cautious about bonds, you either think there’s going to be economic disaster, or you’re a momentum player counting on the greater fool theory.

    No, the article spells it out plainly. Smart bond investors are not betting on either economic disaster or a greater fool to bail them out. Rather, they are merely betting on a continuation of the current economic doldrums, so that the Fed has to continue buying bonds for years to come and the 10 year yield drops to 1%. Add up the appreciation and the coupon and it is a pretty nice return. Bond investors who choose this nice return over stocks are not betting on economic disaster to bring stocks down. What was the disaster that caused SP500 to fall to 1074 intra-day back in Sep 2011? What was the disaster that caused them to fall to about 1270 back in Jun 2012, less than a year ago? It would be easy for stocks to fall 20% from current levels with no economic disaster, just a change in sentiment. That nice returns in bonds would like ever better if that happens.

    Japan is the key case study for bond bull markets that go on forever, with dead-cat bounces along the way in the stock market.

  3. streeteye says:

    If the 10-year drops to 1% over 3 years (a pretty big if), you’ll earn something like 3.7% for the next 3 years. It’s better than nothing, but not what I would call a nice risk-adjusted after tax return, when you’re fighting a Fed that is determined to inflate. If inflation were to average 1.8% or more for the next 10 years, which seems far more likely, you’re looking at a negative after tax real return.