New Fear In The Market – Bond Investing
November 21, 2016
Bond investors are now facing a “one-two” punch with the bond market selling off on the long end, and the Fed about to raise short term rates for the second time in seven years. Is the long awaited decline in the bond market upon on us? How will investors react to the risks associated with this rediscovered world of rising rates?
Since 1981, the bond market has experienced a massive rally. Having been around in the market for a while, I can remember buying 10-year Treasury bonds at a yield of 16%! The 1980s were heady times for bond traders, and they were a bond investor’s dream. But a 30-year rally eventually saw that same 10-year government bond yielding a meager 1.37%. These ultra low interest rates have forced investors to turn to other investments for income. So we must pay careful attention to the way that the Presidential election result has catalyzed a potentially major shift in the bond market.
On election day, the 10-year Treasury bond was yielding 1.75%. The yield quickly moved to 2.25%, an increase of 50 basis points. An investor who bought the 10-year note on election day would have seen a drop in value of 4.5% in a week! If the 10-year Treasury moves further to a 4% yield, an investor who bought it for $100,000 on November 8th, would see it worth only $81,600.
Historically, the level of interest rates was driven by two interrelated factors. The Fed set short term interest rates in the form of its Fed Funds rates, and the market decided the level of long term interest rates. That was the norm for decades, but several years ago the Fed decided to work on both the short term rates and long term rates. The relevant policy is known as “quantitative easing” (QE), which was intended to help kick start the economy. Through QE, the Fed bought billions of dollars worth of longer term securities, and this pushed down the 10 year note, and mortgage rates, to all time lows. In effect, the Fed temporarily replaced the market as the arbiter of long term rates. The Fed’s QE program is now over, and it appears that long term interest rate levels are back in the hands of investors, but what do they see?
A new government is taking control, with promises of massive infrastructure projects for the nation. Also on the table are potential cuts in corporate and individual tax rates. All of this must be paid for, and it looks like investors are assuming that more government debt will be issued. It does not take an economist to work out that finding buyers for more debt will likely mean higher rate of interest on those new bonds. Getting through this new phase in the interest rate cycle will not be easy, and bond investors must be cautious and prudent during this time of adjustment.
Carl Gambrell
