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Bond Bears are Ready to Give Up

 November 29, 2012 01:50 PM

(By Michael Harris) This probably means that a bond bear market is coming closer because even big names in the investment industry seem to have given up and are adding to their bond portfolios. However, a rapid rise in yields will not affect pension funds as much as some may think because bonds are fundamentally different from stocks.

If the stock of a company drops 50%, from $100 to $50, for example, and stays at the new price level for 10 years, an investor in that stock loses 50% of its investment during that 10 year period plus risk free returns . If newly issued 10-Year Treasury Note prices fall suddenly 50% (God forbid) at the maturity date the investor receives the full face value of the bond but also its regular interest payments that are guaranteed by the government. This trivial example that does not consider other parameters, like the reinvestment of coupons at higher rates, shows why conservative investors prefer US Treasury issues over stocks even at such low yield levels.

[Related -ADP: US February Payrolls Continue To Grow, But At Slower Rate]

This is an excerpt of a comment I wrote below a post in The Reformed Broker blog commenting on an article in New York Post about a bond market bubble burst and mentioning the possibility of US retirement assets going up in smoke:

"Pension funds use bonds to accomplish future "liability matching", i.e. a matching of cash outflows due to pensions with future cash inflows from coupon payments. By adjusting the duration and convexity of their bond portfolios and through the use of derivative products they can "immunize" the portfolios against interest rate changes. Thus, they mostly hold bonds to maturity and reinvest the extra cash at higher rates in case of a rise. If an investor holds a bond to maturity then, save default risk like in Argentina, the bond face value is guaranteed. I guess there have been examples of pension funds that acted as speculators in the past but they are exemptions to the rule.

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Changes in interest rates concern mostly speculators like those who use ETF vehicles like TLT or futures contracts to capture gains in bond prices. You are correct that the market value of bonds decreases with rising rates but that is of little concern to those who plan to keep the bonds to maturity or hedge the rate rises because the face value is not affected, save of course situation when inflation rises drastically. Thus, the problem will be in the case of a default but under such scenario stocks will collapse too. If you look at historical standard deviations of logarithmic returns of the various asset classes, bonds have historically the lowest levels. Bond returns distributions have the lowest Kurtosis and skewness and they are nearly normal, as opposed to returns from other assets classes that involve fat tails and are subject to surprises. Therefore, there is an underlying rationale for risk averse money flowing into bonds, especially when the FED is determined through purchases to keep long-term interest rates down. But I agree with you that bond speculators may get burned, as they have several times in the past. Anyone who purchases bonds for speculation at this point is risking a loss."

Since it is possible to face capital gains losses if bonds are sold before maturity, I should also add to the above that bond funds may lose money if they are forced to sell holdings during rising interest rates due to share redemptions. Thus, for conservative investors the best strategy is neither long bond ETFs, nor long bond funds, but workink closely with a registered investment adviser and purchasing bonds for their own account through a broker to hold possibly to maturity. Even some good bond fund managers in the past have fallen victims of confirmation bias and have missed excellent opportunities in generating returns or even have generated losses because of wrongly timing their trades.

Despite the fact the bears seem to have given up yesterday and 10-year Note yield dropped 10 1.66%, it appears as there is no significant downside potential in yields at this point even though the FED is completely in control of this game. We may see lower rates or even approach the lows near 1.40% but in the medium-term it looks like rates will move higher. The issue is the rate of redemptiond the bond funds will ahve that will in turn push rates even higher and what the FED is going to do about that. However, we will have top wait for those conditions to evolve and watch the price action.

Disclosure: no relevant position at the time of this post and no plans to initiate any positions within the next 72 hours..



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