What do the Chicago Bears and US Postal Service have in common? Neither delivers on Sundays.
Bears fans like me have watched our favorite team lose 13 games in a row. It stinks, but we’re used to it. Our team hasn’t won a Super Bowl since 1985.
In capital markets, one of the most dependable trades since 1985 has been long duration treasury bonds. They’ve won almost every year. However, that dependability is now waning as bond investors are being hit with losses for the third year in a row.
Sticky inflation and surging government spending have pressured bonds. The US fiscal deficit, which was around $1.5 trillion in the first 11 months of the fiscal year, has buoyed consumer spending and sent fixed income yields higher.
Another factor that is weighing on bonds lately is a heavy amount of supply. Not only is the Treasury Department issuing a lot of new debt, but the Federal Reserve is also selling bonds due to its quantitative tightening program.
Still, many investors have continued adding long duration credit to their portfolios this year, shrugging off the short-term losses. This is largely because many flows into bonds are basically done automatically in 60/40 balanced portfolios, such as Target Date Funds.
But is now a good time to be adding long-term bonds to your portfolio? The answer should be based on your evaluation of fundamentals.
In 2019, I wrote a piece titled, Buy Gold, Sell Bonds, where I made a fundamental case for why bonds aren’t always a safe investment. From the date of that article until now, the Bloomberg US Treasury Index total return is -7.9% (-1.9% annually). Over the same four-year period, the SPDR Gold Shares ETF (GLD) is +31.1% (+6.6% annually) and the S&P 500 Index is +56.8% (+11.2% annually).
Gold and US equities have handily outperformed bonds chiefly because of valuation adjustments. In 2019, 25% of the global bond market traded at negative yields. That was crazy. In my previous article, this is why I asked the question: “What could possibly be safe about investments guaranteed to lose money?”
Bond yields have since risen, which implies the valuation setup is better going forward. I no longer see long-term bonds as a guaranteed way to lose money. If you’re a long-term investor and bonds are part of your asset allocation, this could be a good time to start nibbling perhaps. But I wouldn’t advise anyone to aggressively pile into rate-sensitive fixed income at current prices.
Yields on 30-year treasuries recently touched 4.8%. This is probably enough yield to adequately compensate investors if inflation normalizes back toward the Fed’s 2% goal.
But what if inflation remains sticky? In that case, bond investors will probably have to get used to nursing more losses, much like us beleaguered Bears fans.
In an investment outlook published last week, famed bond manager Bill Gross urged investors to ditch treasuries and corporate bonds in favor of alternatives such as Master Limited Partnerships (MLPs). According to him, MLPs offer higher yields, tax advantages, and better inflation protection.
Speaking in a recent interview with Bloomberg’s Odd Lots podcast, Gross also said, “the 10-year Treasury is priced for a 2% inflationary world.” He pointed out the 10-year usually yields around 1.4 percentage points more than the fed funds rate. Thus, even if the short-term policy rate falls to 2.5%, that puts 10-year bond yields close to 4% “under the best of possible scenarios.”
A more dire scenario would be if inflation reaccelerates. Unfortunately, that’s looking more likely by the day as base effects are due to become more of a headwind to future CPI reports, and energy prices are breaking sharply to the upside. WTI crude oil has risen 30% this quarter.
Another reason to be cautious in assuming much duration risk here is technical in nature. When a long-term trend changes, it rarely pays to fight that trend shift. We’ve recently seen a long-term breakout in bond yields, signifying this could be a prolonged bond bear market.
Below is a chart of the 10-year bond yield since 1985. The pattern for many years has been a series of lower highs and lower lows. However, that trend channel was recently decisively broken. Now, we see a pattern emerging of higher highs and higher lows. This chart tells me we’ve entered a new era where bond yields will likely be stickier to the upside than many people perceive as likely. The world investors were inhabiting pre-pandemic is no more.
Inflation is notoriously difficult to forecast, and nobody has a dependable crystal ball for that. But one thing is clear: bonds are no longer the dependable investment they once were. Invest accordingly.
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