Is the Bond Run About to End?

03/28/2012 11:00 am EST

Focus: BONDS

BMO economist Douglas Porter has counted ten intervals since 1981 when prices fell enough to cause yields to rise by more than one percentage point, only to have prices recover and power on to new highs, writes Martin Mittelsteadt of The Globe and Mail.


For more than three decades, there has been a sure-fire way of making money: Buying bonds.

A bull market in bonds has been going on since 1981, rewarding investors with huge capital gains and interest payments to boot.

But a note of disquiet has entered the market. Bond prices this month have fallen sharply on signs of improving economic conditions in the United States, raising the question of whether one of the best money-making investment trends of our time may be switching from a bull to a bear market, or merely taking a pause.

Most observers suspect the bond bull market is only in temporary abeyance. But Goldman Sachs on Wednesday made a gutsy call that it was time to rotate into stocks from bonds, because returns were likely to be better.

After such a lengthy upward run, "it takes a very brave person to say this bond bull market is dead," observes Douglas Porter, deputy chief economist at BMO Capital Markets.

He says that whenever some market players declared the run was over, "each time it came back with a vengeance."

The easiest way to chart the course of the bond bull market is through yields, which move inversely to prices—when yields fall, it means prices are rising. Yields on ten-year US Treasury notes, the world’s bellwether fixed-income security, peaked around 15.8% in September 1981, and fell to a low around 1.7% last September—reflecting a bull market in prices.

Yields then traded mainly in a narrow band between 1.8% to 2.1%, until this month—when they suddenly soared to a peak of nearly 2.4% in Monday trading, considered a dramatic move in the bond market.

Porter argues that "it’s a little early to pronounce the bull market over," yet he believes yields could rise over the next year or two. He’s projecting Treasury notes to range between 2.75% and 3% by the end of this year, and possibly get as high as 3.5% by the end of 2014.

Such yield moves, if they occur, would imply lower bond prices. But Porter says he’s counted ten intervals since 1981 when prices fell enough to cause yields to rise by more than one percentage point, only to have prices recover and power on to new highs.

Porter says the bull market would be over for good if the economic recovery sticks and the US Federal Reserve Board backs off on any further talk of moneyprinting, known formally as quantitative easing.

One of the most bullish market pros is Van Hoisington, president of Hoisington Investment Management, a Texas-based money manager that has been unswervingly committed to bonds since 1990.

Hoisington says the recent fall in prices is only a correction: "This is normal volatility. We’ve had it almost every year for the last several years."

Hoisington is optimistic bonds will continue making money for investors because he believes the global economy is weak, beset by deflationary forces and so weighed down by debts that stronger growth is unlikely. If the economy got strong enough to prompt a big jump in inflation, he’d change his mind.

"A sustained upturn in inflation would be the critical element, which would mean the end of the bull market," Hoisington says.

In his view, interest rates will eventually fall enough to produce further gains of about 30% on long-term, 30-year US government bonds.

Another bond bull is Paul Ashworth, chief US economist at Capital Economics. He says bond yields will likely decline, because annual growth in the US is going to be modest at around 2%, while Europe’s sovereign debt problems will re-emerge.

When investors fret over the health of European countries, they typically pile into US Treasuries, driving prices higher.

"We’ve still got a lot of macroeconomic concerns about the Eurozone and pretty much all the countries in the periphery," he says. "So we wouldn’t necessarily say the great bull run’s gone."

Those looking for clues that bonds might continue their recent drop should pay close attention to the monthly growth in US employment, says Beata Caranci, deputy chief economist at TD Financial Group. If payrolls keep growing at about 250,000 a month, as they have recently, there will be upward pressure on rates, she says.

What to Do if the Bond Bull Market Is Over?
Interest rates will be sure to rise for mortgages and other loans. That means homeowners will have to decide whether to take their chances by locking in or staying with floating rates.

There are a large number of ETFs, both leveraged and unlevered, that give exposure to moves in bond prices either up or down. The most volatile bonds are those with the longest maturities.

A Toronto-listed play on falling bond prices is the Claymore Inverse 10-Year Government Bond ETF (Toronto: CIB), although it suffers from low liquidity.

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