Bond investors have more to worry about than a government shutdown

Inflation worries, international rates pushing Treasuries yields higher

Jan 19, 2018 @ 2:20 pm

By John Waggoner

Bond yields have marched higher this year, and returns from bond funds have marched lower. Will a government shutdown make things worse?

Probably not, provided it's a short-term problem. A bigger worry is a rise in overseas rates, which could drag Treasury yields up with them.

The bellwether 10-year Treasury note yield rose to 2.64% early Friday, up from 2.4% at the end of 2017. Bond prices fall when yields rise, and vice-versa, so the recent rise has taken its toll on most bond funds. The $196 billion Vanguard Total Bond Market Index fund (VBMFX), the nation's largest bond fund, has fallen 0.82% this year, for example.

While it's tempting to blame Congress for its dithering on avoiding a government shutdown, bond traders are fairly sanguine about the effects of a shutdown, which cost taxpayers $24 billion in 2013, the last time it reached a similar impasse.

"The market's not concerned about a shutdown at all," said Tom Essaye, editor of The Sevens Report, a daily macro-economic report. "What's pushing yields higher is what is going on internationally."

Specifically, bond traders are concerned that the European Central Bank and the Bank of Japan could be aggressive about ending monetary stimulus than assumed earlier.

Paul Jakubowski, global head of credit for Vanguard, said that the bond market had priced in too low expectations for Federal Reserve rate hikes in 2018. And, he said, the nation's strong economic backdrop and rising oil prices "should translate into inflationary pressures," he said.

Inflation is the enemy of all bond investors. It erodes the value of a bond's fixed interest payment. When inflation looks likely, investors demand higher yields and lower bond prices.

As would be expected, funds with longer durations have suffered the most this year. Long-term government bond funds, for example, have fallen an average 2.45% in the few trading days this year, according to Morningstar Inc. General long-term government bonds have fallen 1.04%, Intermediate-term bonds, one of the largest bond fund categories, have fallen 0.60% on average.

Corporate bonds have suffered less, partly because the prospect of a strong economy in 2018 has improved the outlook for corporate credit ratings, just as it has improved the prospect for corporate earnings. High-yield bonds have gained 0.62% this year, and bank-loan funds have gained 0.42%.

"Not only was the market value of U.S. common stock recently up by 4.4% since year-end 2017, but a composite high-yield bond spread narrowed by 23 basis points to 336 basis points," said John Lonski, managing director and chief economist for Moody's Capital Markets Research Group. Narrowing spreads between high-yield junk bonds and government bonds is a sign of bullishness in the corporate bond market.

The most recent rise in rates isn't new. The bond market has been falling since July 2016, when the 10-year yield hit 1.37%. The largest funds have held up remarkably well. Vanguard Total Bond Market, for example, has lost 0.59% since the 10-year T-note hit its all-time low in 2016. The American Funds Bond Fund of America is down 0.13%.

And several large bond funds have performed admirably since the 2016 low in yields. Pimco Income Institutional (PIMIX), a multisector bond fund, has gained 12.81% since then. Templeton Global Bond (TPINX) is up 11.73%. And Fidelity Capital & Income (FAGIX), a high-yield fund, has jumped 21.82%.

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