The history of bonds — at least since yields hit record lows last year

The funds that have fared the worst since the low in interest rates have been those with the longest duration

Nov 1, 2017 @ 5:09 pm

By John Waggoner

History, as Kurt Vonnegut reminded us, is merely a list of surprises. The next world war will certainly not start with the assassination of an Austro-Hungarian archduke. You're probably not going to make a fortune peddling pet rocks.

On the other hand, you can learn something from history, and in this case, you can learn quite a bit from the bond market since July 5, 2016, the day the 10-year Treasury note yield hit an all-time low of 1.37%. The bellwether yield is now 2.37%, a full percentage point higher. For investors, the question is: Which bond funds have fared the best since bond yields hit record lows, and will they continue to do so if bond yields continue to climb?

Few expect yields to break to new all-time lows, although anything is possible. And, in fact, it's more likely that the great bond bull market, which began with the 10-year T-note yield at 15.84% on Sept. 30, 1981, has quietly expired. Bond bear markets, unlike stock downturns, tend to be gradual, rather than sudden. Instead of being clawed by a stock bear over 18 months, you're more likely to see a few percentage points shaved off your principal year after year — a bit like being nibbled to death by ducks.

What has caused the great bond rally to end? "The proximate cause for the increase in yields was that the Fed hiked rates by 100 basis points," said Scott Mather, chief investment officer of core U.S. strategies at Pacific Investment Management Co. "We see another two or three hikes ahead in 2018, as well as one in December of this year, which will take short-term cash rates to about 2%."

The Fed doesn't control the longer-term bond market, but it will begin selling off the bonds it holds on its balance sheet soon, which could put upward pressure on rates, and downward pressure on bond prices. It's not just the Fed: The world is getting less dovish on interest rates: The European Central Bank is tapering its bond-buying program, the Bank of England is widely expected to raise interest rates next month, and Canada's central bank is raising rates, too.

"At the margin, all this eats away at the global interest rate picture that had been so benign," Mr. Mather said.

Investors who have flooded into bond index funds have been rewarded with zero returns or worse. The Vanguard Total Bond Index (VBMFX), the nation's largest bond fund, has lost 0.02% since the July 2016 low in rates. Vanguard Intermediate-term Bond Index (VBIIX) has fallen 0.31%. iShares Core U.S. Aggregate Bond ETF (AGG) has eked out a 0.30% gain.

The funds that have fared the worst since the low in interest rates have been those with the longest duration. Bond prices fall when interest rates rise, and prices fall hardest for bonds with the longest maturities. For example, PIMCO 25+ Year Zero Duration U.S. Treasury ETF (ZROZ) has fallen 12.14% since July 5, 2016, according to Morningstar. (The figures in this story are cumulative total return, not annualized). The average long-term government bond fund has fallen 8.20%, proving that your mother was right when she told you not to reach for yield.

On the other hand, playing it short and safe didn't do you much good, either. The average short-term government bond fund has lost 0.2% since the bond market's low. This is not just because short-term interest rates are wretchedly low. It's because short-term bonds are still bonds, and their prices tend to rise the most when the Federal Reserve nudges rates higher. The yield on the one-year T-bill has almost tripled since the bond market bottomed, rising to 1.31% now from 0.45% in July 2016.

The way to gains in this market has been through improvements in credit and the rising dollar. Highland Opportunistic Credit (HNRZX), a high-yield bond fund, has soared 25.47% since the 2016 low in rates, vs. 12.97% for the average junk fund.

The overseas equivalent of high-yield bonds, emerging markets bonds, have also fared well, rising an average 10.36%. These funds were helped by a generally falling U.S. dollar: ETFs that invested in local currency emerging markets bonds gained an average 4.31%.

Will what has worked since the bottom work if interest rates continue to rise? To some extent, yes. Nevertheless, there's plenty of room for surprises.

"The world is a different place now," said Peter Palfrey, portfolio manager for the Loomis Sayles fixed income group. Rates fell in 2016 because investors were worried the economy was going to roll over, and that it was going to import deflation from China and the rest of the world.

A more likely scenario going forward is increased inflation worries — and that would point to Treasury Inflation-Protected Securities, or TIPS. "We have 5% in one-year TIPS, which is a short-term inflation play and a play on higher energy prices," Mr. Palfrey said. Loomis has a bigger position in long-term TIPS, whose current yield suggests a 1.9% inflation long-term inflation rate. "It's an implicit bet that they will perform better if inflation surprises on the upside," he said.

History may not repeat itself, but it does rhyme. The best investment in 1981, when the bull market in bonds started, was a 30-year Treasury bond. That won't be the case going forward. But don't dump all your high-yield bonds. While they are expensive — and closely correlated with increasingly expensive stocks — they are likely to continue to outperform government bonds, albeit much more modestly than before, Mr. Palfrey said.

"High yield is more expensive than it was a year ago, but it's still better than what you're getting in the investment grade market," he said. The same is true for emerging markets bonds, which should gain from rising commodity prices.


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