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Why Today’s Bond Investors Will Be Disappointed at Trader’s Narrative





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Yesterday we looked at the strange behavior of US mutual fund holders in shunning equities and stampeding into bond funds. That lead to lively discussion with different comments on what this means. Leaving aside the various arguments on whether this is a good or bad omen for the stock market, let’s explore the US retail investor’s sudden love for bonds.

We’ve just woken up to the realization that we have our own “lost decade” for stocks. From 1999 to 2009 the worst asset class you could have chosen would have been equities. In contrast Treasury bonds returned 110%, second only to gold.

But similar to the importance of timing the stock market, when you purchase bonds is pivotal to success. While we use metrics like P/E ratios or price dividend ratios to gauge the stock market, the bond market is much simpler. According to a study by Vanguard, all we have to do is look at the current yield. If it is low, the future returns will be similarly low. If high, then future returns from bonds will also be high.

You can download the report from the Free Trading Resource section (Reports & Articles folder: “The Historical Impact and Future Implications of Extraordinary Markets”). Here is how they explain their historical study:

…we put the historical yield levels for the 10-year constant-maturity Treasury bond into quintiles and show the range of returns over the next 10 years for those initial yield levels. For example, with an initial yield between 7.8% and 14.0% (quintile 1), the subsequent 10-year returns have been between 6.6% and 12.3% per year. Intuitively, these high returns stem from the fact that higher initial yield levels have been followed by systematically declining interest rates over the subsequent 10 years.

Here’s the resulting chart:

bond yields compared to 10 year forward returns source - Vanguard

In late 2008, during the darkest days of the financial crisis, the 10 year Treasury bond yields sunk to 2.2% (5th quintile). The current yield on the 10 year is 3.44% which puts it in the 4th quintile. Based on historical data (from January 1928 to December 2008) the median return for the decade ahead is only 3.2%. And if you really want to get technical, you would subtract a reasonable inflation rate - say 2%? - which would bring the return to almost zip.

This study proves what we all know intuitively. Current rates are extremely low and the probability is therefore skewed towards rising rates, which means lower future returns. The higher the rates rise, the lower that return. So if you really believe in the inflation boogey man, you would be actually avoiding bonds not running into their arms as the average US retail investor is doing right now.

Instead of buying bonds, if you expect runaway inflation, you should be buying Treasury inflation-protected securities (TIPS) - bonds whose coupon increases along with inflation, and decreases with deflation.

A surprising number of retail investors are doing exactly that right now. Here’s an excerpt from a recent article from the Wall St. Journal:

Richard Seelig, a retired high-school math teacher in Pelham, Mass., bought shares of the iShares Barclays TIPS Bond Fund last December for his Roth individual retirement account. “I looked at the amount of money the government was spending that it didn’t have, and I thought, well, that is going to come back to haunt us,” he says.

But we are not in an inflationary environment right now. The yield gap between TIPS and normal Treasuries is 1.8% implying that that is the inflation rate in the US right now. But that may be deceptive for two reasons. Everything we’re seeing right now in terms of economic measures is signaling strong deflationary pressures. And two, the strong retail demand for TIPS has pushed their prices higher.

Even as retail investors rush to put their money into TIPS, there is no guarantee that they will see a payoff. This is because as inflation is sighted by the Federal Reserve, they will raise interest rates. And as interest rates rise, the value of bonds will decline.

So current buyers of TIPS are not only betting that inflation will be higher than 1.8% in the future, they are also betting that the Federal Reserve will be a pushover. That assumption may come back to haunt them.

long term cumulative bond returns regression Jeremy SiegelIf the above arguments are not persuasive, here’s another. Based on the historical data for US bonds, Prof. Jeremy Siegel has plotted a cumulative return for this asset class over the very long term (chart to the left). Total bond returns move in slow, multi-decade arches swinging above and then below a regression line (red). Right now, the cumulative return for bonds is extremely high relative to their historical trend. A reversion to the mean will happen. The only question is when and how fast. For more information on this valuation approach, see this article from MarketWatch.

Two Wrongs
If the shunning of equity funds by US mutual fund investors is bullish in your opinion due to contrarian analysis. Then it is difficult to not be labeled a hypocrite if you also believe in a future inflationary Armageddon. Either the “dumb money” retail investor is wrong in disbelieving the equity bull market, or they are wrong in expecting inflation.

While I completely understand and empathize with the traumatized psychological state of the average US retail investor, tragically, it looks as if they are jumping from the frying pan into the fire.

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15 Responses to “Why Today’s Bond Investors Will Be Disappointed”  

  1. 1 GreenAB

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    it all depends.

    nobody knows, what the ultimate outcome of this crisis will be. inflation or deflation? there are tons of arguments for both sides.

    until the picture becomes clear it makes sense to position for both scenarios and that includes buying government bonds.

    JAPAN ist the ultimate example that long term rates can fall lower than one could imagine.

    if deflation really makes a comeback, treasuries could get another boost. even cash would be a great asset to own.

    good stuff on this debate here

  2. 2 Babak

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    right, what if the two opposing forces completely offset each other? and we have zeroflation™?

  3. 3 tradeking13

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    Baby boomers make up a large portion of retail investors and I don’t see them going head long back into equities, especially after two crashes in one decade (many are having to extend their retirement dates out due to their recent loss of wealth in the housing and stock markets). They will be looking for capital preservation and income, which favors fixed income instruments and stable, dividend-paying equities, as any financial planner will advise for those approaching retirement age.

  4. 4 kamchako

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    Having just returned to the US after quite some time in japan, all I can say is don’t underestimate the possibility of deflation. It’s real, it’s frightening, and I’ve watched it in Japan since the 89 peak. I thought people were nuts at buying 10yrs at 2 percent, until I watched them eventually go to zero. Yes zero percent.

  5. 5 enlightened wallstreeter

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    The world is ignoring the Huge level of debt that the us is issuing. This will come back to haunt us in a few years. Check out my blog of blogs

  6. 6 Babak

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    tradeking, so basically a replay of 2002 where the VIX gets pushed down artificially as calls are sold to generate extra yield?

    kamchako, I hear ya. Personally I think deflation still has the upper hand. Where is there any evidence of inflation in the economy? there is so much slack in capacity, unemployment, etc.

  7. 7 tradeking13

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    I recently watched an episode of House Hunters International on HGTV where an American working in Tokyo was looking to buy an apartment, because, to paraphrase, mortgage rates were at 1.6% so now he could afford to buy. Man, I hope it doesn’t come to that.

  8. 8 Samuel

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    According to a recent sentiment report by Barrons 4% of professional money managers are bullish on Treasuries and 60% are bearish. Does that sound like a market top to you? Retail investors may be buying corporate bond funds but are they really going headlong into Treasuries? Does the retail public believe deflation is coming?

    Here is an analysis in favor of holding Treasuries. If you believe we are headed into a long period of stagnant economic activity then it seems Treasury bonds would be the asset class to own.

  9. 9 Jerry

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    One year after this article was written it turns out bonds were the place to be and will continue to be in the foreseeable future. I am sure glad I loaded up on them.

  10. 10 Babak

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    Jerry, technically it hasn’t been a year but ignoring that, let’s look at the 30 year bond price/yield: when I wrote this, the yield was appx. 4%. That was the low as bond prices fell until yields were above 4.8% in April 2010. Today they are once again at around 4%, having fallen since the April 2010 high.

    In the short term, they are a scratch (after I presume you endured a large paper loss until April 2010) and in the long term, the above analysis still stands. So tell me again, why are you glad you loaded up on them?

  11. 11 Jerry

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    Babak,

    I understand that you were probably referring more to longer-term Treasuries (10 years and up) in your article. Just to clarify my statement in my previous post, I myself bought TIPS, GNMA, and short to intermediate-term corporate bond funds at the end of 2008 when they were being dumped so I really had no large paper losses. I also have added to them since then and I am glad that I did. Of course I realize that one day, may be in a couple of years, rates will climb and if I hold on to them I will give up some of my gains. But I think the next six months to one year still looks to be favorable for bonds in general. Because money market rates are so low today and looks like it will stay that way in the foreseeable future, I am still looking to put money into TIPS, GNMA, and short to intermediate-term bond funds on any good pullback and may be even into a good utilities fund.

    But you are correct that investors would probably do well not to buy longer-term Treasuries at this stage. So I think we both now have a better understanding of what each one was saying.

  12. 12 Babak

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    Jerry, in the long term I think that the bond market will return to its mean. In the short term, things could go even more out of whack. Take a look at this article which I shared at news.tradersnarrative.com recently.

  13. 13 Jerry

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    Babak,

    I agree with you. And if rates continue to drop or get more out of whack as you put it, I will be inclined to sell a good part of my bond holdings. The Risk/Reward ratio would not be good to say the least. In the near term though I think it is still ok. I am not referring to longer-term bonds which are more volatile.

  14. 14 Jerry

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    Well it has been almost one year since I stated that I was glad that I loaded up on bonds and since that time the return on my bond funds have averaged over 6%. With the economy still anemic and with no signs of improving and with inflation moderating after a brief blip up, the outlook for bonds in the near-term still remain favorable. Still sticking with GNMA’s, short-term bonds and TIPS.

  15. 15 hgjjg

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    jhjhjgh

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