BONDS – Where we go from here!

“The perception that there remains less risk in fixed income cannot be further from reality – especially because of the post-crisis distortions imposed upon interest rates and the bond market by the US government and replicated around the globe.”

Massive inflows into bonds in the third quarter of last year inspired me write the above warning in my post (October 2012) entitled The BIG Bernanke: Bond risk for the duration!

Since then, bonds have been as disappointing as I predicted. Of course, it is only after-the-fact (8 months later) that bonds are experiencing serious selling pressure. It seems customary that investors wait for concrete evidence (lose some money) before transitioning their portfolios; to the tune of about a -5% loss.

But why has the stock market continued to be so resilient? Ordinarily when interest rates are on the rise, stocks suffer a correction.

• Maybe it just hasn’t really happened yet. Fund flows often provide strong resistance to fundamentals – money from huge cash reserves and proceeds from bond sales moving into stocks lift prices despite those prices being overvalued.
• Or perhaps it’s different this time. During historical episodes of significance the fear of FED tightening and its economic impact weighed heavy on valuations. Today it’s more a case of the FED putting the brakes on stimulus, not actually tightening monetary policy.

Periods of actual FED tightening can be harsh on stocks. The examples in the chart (not exhaustive, just a sampling) illustrate the point nicely. However there must be a substantial difference between tightening on the one hand, versus reducing stimulus (QE) on the other hand.

I am on record for believing the stock market has gotten ahead of itself but it continues to defy gravity – perhaps a downward adjustment in corporate earnings expectations will fix it. The economy seems to be wavering of late.

Bloomberg News June 3, 2012: “The Institute for Supply Management’s factory index fell to 49, the lowest reading since June 2009, from the prior month’s 50.7, the Tempe, Arizona-based group’s report showed today. Fifty is the dividing line between growth and contraction. The median forecast of 81 economists surveyed by Bloomberg was 51.”

But there may be reason to expect any correction to be mitigated by a FED that wants to simply layoff the accelerator rather than apply the brakes. There have been periods when interest rates have climbed modestly yet stock markets continued to be relatively generous.

I’m simple-minded, so I try to keep things simple. Currently I reckon that investors are discounting S&P 500 earnings using a rate midway between quality corporates and junk. Should fear (of inflation or just summer seasonality) cause an upward adjustment in the discount rate I wouldn’t be surprised to see the S&P 500 suffer a pullback of up to 6%.

The short term outlook for bonds is not much better but medium term might be considerably worse.

At the end of last year, in my discussion Stocks & Bonds…the next 100 years I concluded long bond holders require a real rate of return of 1.5%. For the first few months of 2013, inflation has averaged about 1.5% so the nominal required yield would be 3%. This is pretty close to where long treasury bond yields actually are. Investors would have to expect inflation to rise (to 2%?) and also ‘price-in’ some negative impact from the FED backing off its QE buying program (say 50 basis points?) to create a 4% yield on the 30-year treasury.

If this is possible (arguable), and instead of a 115 basis point spread (current) the 10-year spread approaches say a more reasonable 50 basis points to the 30-year, this implies a 10-year treasury rate of 3.5% instead of 2.12% today.

The duration of the 10-year bond index charted earlier is 5.12%, so a quick back-of-the-envelope estimate of the damage might be an increase in yield of 1.38% X 5.12 = 7.06% decline in the value of the bond or $70.06 per $1000 bond. Ouch! This ignores convexity – so it could be even worse.

The advantage to equities mind you, is that as long as the ROE for companies is growing and exceeds the cost of borrowing then there’s hope for a resumption in positive returns for stocks. Then there’s no real worries until the day when the FED actually decides to tighten. That day doesn’t imminent but when it comes run for cover.

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