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Dangers Lurking In The Bond Market

 February 11, 2013 06:07 PM


The secular decline in interest rates since 1981 has resulted in bond investors enjoying a thirty year bull market run in most fixed income investments. Since the price of a bond moves inversely to the move in interest rates, the declining rate (and rising bond price) environment is the only investment environment experienced by many baby boomers during their peak investing years. This declining rate period can best be shown by the long term chart of the yield on the 10-year treasury bond. Conversely, the retiring baby boom generation has enjoy a less than smooth ride in the equity markets, punctuated by the technology bubble, the financial crisis in 2008/2009 and the bursting of the housing bubble. The risk in equities seem to have far out weighed the return or lack thereof.

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In a few recent posts on this blog, we note investors continued to pour investment dollars into bond funds over the last four years in spite of the strong returns generated by the equity market. In fact, over this four year period, the annualized rate of return for equities far outpaced bond returns.

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Since the beginning of the year, much has been made about the increased flow of funds into equity mutual funds and ETFs. It is true increased flows have gone into equity investments; however, investors are also allocating funds to fixed income/bonds as well. I believe many investors became cautious prior to the election and the fiscal cliff and with that uncertainty behind them are now reentering the market--investing in both stocks and bonds.


Source: ICI


Source: IndexUniverse

The danger for bond investors is the decline in principal value that results from a rise in interest rates. Bonds are expected to be the stable value of ones investment portfolio; however, with rates as low as they are today, there isn't much room for them to go to much lower. The magnitude of the change in principal value with changes in interest rates is shown below.

Source: JP Morgan's Guide to the Markets

Since mid November rates have increased with the 10-year Treasury rate rising almost .50% (or 50 basis points) to around 2%. This does not seem like much of a rate increase; however, the decline in principal value can be significant. The bottom line in the below chart shows the magnitude of the decline in the value of iShares Barclay's 20-year Treasury Bond ETF (TLT) since mid November. A near 8% loss in two and a half months is what an investor might expect from stocks, but not bonds.

Jim Paulsen, Ph.D., of Wells Capital Management, writes on this topic in his February 6th market update newsletter, ‘Facing' the Portfolio Allocation Decision? His entire newsletter is a worthwhile read and concludes with:

"The post-war investment climate has been heavily dependent on the "faces of the bond market." And, the bond market is about to change face again. The secular declining bond yield era is over. At best, bond yields will trend sideways in the years ahead. More likely, bond yields will again rise some in the next few years. Overall, investors should prepare for an investment environment whose character lies somewhere between the last two bond eras."

"Compared to the last 30 years, the next investment era may produce similar equity returns but far lower bond returns. Expect the added diversification provided by bonds to diminish substantially relative to the smoothing impact bonds have provided in the last 15 years. Finally, investors should prepare for a much steeper tradeoff between risk and reward. In the years ahead, additional risk will likely be more handsomely rewarded than has been the case in the last 30 years. Perhaps, most importantly, if the risk-return frontier is about to take on more of its pre-1981 character, investors need to question whether current conventional asset allocation parameters, born out of the culture of the last 30 years, are still appropriate?"

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