High yield bonds, often known as junk bonds, have been very popular investments since the financial ...
Ten Reasons the Bond Crunch Matters
12/14/2010 9:09 am EST
Prices are falling and yields rising as the bond world sends a message to Washington. The fallout will affect retirement savings, mortgage rates, stocks, gold, and more.
It's a bond rout.
On December 8, prices for US Treasuries plunged and yields on the benchmark ten-year US Treasury hit a six-month high of 3.33%. That's a full percentage point higher than the October low. And it's a shocking 0.76 percentage points above the yield just a month ago on November 8.
It's not just happening to US Treasuries. Bond prices are plunging and yields soaring for developed-economy bonds across the globe. In that same one-month period, yields on German ten-year bonds are up 0.62 percentage points, yields on ten-year UK bonds are up 0.53 percentage points, and yields on Japanese ten-year bonds are up 0.29 percentage points.
But unless you've got part of your 401(k) stashed in an international bond fund, what you care about are US bond prices and yields. And you should. The drop in bond prices means a climb in interest rates that will affect everything from your retirement planning to your mortgage.
Let's start with the why of this big bond market move, then move to the why you should care.
What Ails the Bond Market
The reasons for the move up in yields—and down on prices—on US Treasury bonds are pretty simple.
First, the fundamentals. The Federal Reserve is dumping an additional $600 billion in cash on the US economy through its program of Treasury buying. The proposed package for extending the Bush administration tax cuts would throw an additional $1 trillion at the economy. Even though these aren't particularly efficient forms of stimulus, that much money will increase US economic growth.
On December 9, Pacific Investment Management, or Pimco, which manages the world's largest bond fund, raised its growth forecast for the US economy in 2011 to 3% to 3.5%. That's up from a previous forecast of 2% to 2.5% for the year.
Increased economic growth usually leads to more inflation. And if inflation is going up, bond buyers want a higher yield before they buy—to balance out the larger bite that inflation will take out of their interest payments and capital. And if yields are to go up, bond prices must go down.
Second, the psychology.
The proposal from the Obama White House and Congressional Republicans to add $1 trillion in debt over the next two years to the US balance sheet by extending the Bush tax cuts has just put a capstone to the feeling that the US government doesn't have an inkling of a plan for dealing with the US deficit. And worse, because most bond investors were convinced of that before the deal was announced, the markets now believe that nobody in Washington cares. Take the heat to restore fiscal sanity? You can hear the laughter all the way out to the Lincoln Memorial. (See my post on the proposed deal, "Wall Street economists score the tax deal: $1 trillion in costs to get 0.5% increase in GDP growth in 2011.")
Why would anyone want to buy US Treasuries when the United States seems committed to fiscal irresponsibility, a debased currency, and as much inflation as necessary to make the huge US debt load as easy to repay as possible?
None of this means that Treasury prices are about to fall off a cliff or that US interest rates are about to zoom to 5% on the ten-year Treasury. The most recent bull market in Treasuries lasted 25 years, and there's no reason to think that a bear market in Treasuries wouldn't take that long to unfold.
The current rout doesn't mean there won't be up days—Treasury prices rallied slightly on December 9, for example, before falling again on December 10. There's enough worry about bonds from other countries to make Treasuries look like a real bargain on some days. It wouldn't take much of an increase in the temperature of the euro debt crisis to send money out of German bonds and into the seeming safety of Treasuries. (For an example of how volatile bond markets can be, see my post "Relief rally takes hold ahead of the European Central Bank meeting; will the bank rain cash on the markets?")
But I think you can count on the trend now moving toward higher interest rates in the United States no matter what the Federal Reserve does to the short-term rates that are currently locked near zero. Short of a double-dip recession, all that's uncertain is the speed with which bond prices will fall and interest rates will rise.|pagebreak|
Why You Should Care
So how could this bond crunch affect you as an investor, you ask? Well, here are ten possible ways.
- The most obvious place to look for an impact is on the housing market and the construction industry. Rising interest rates, particularly for the ten-year Treasury that serves as the benchmark for most mortgages, means that mortgages will get more expensive. Average rates on 30-year mortgages are up to 4.74%, the highest level since July. That's still not quite as high as the 4.89% rate of a year ago, but it's enough to help push mortgage applications down 15% in a year. Even before the latest surge in interest rates, economists were forecasting a 6% to 7% drop in housing prices last year. Higher interest rates make that projection almost certainly low.
- The effect on mortgage refinancings is likely to be even bigger. Refinancings are even more sensitive to interest-rate changes than mortgages. Stands to reason. Refinancings are completely discretionary, and if rates go up a bit, mortgage holders can easily just sit in place. Applications to refinance existing mortgages have dropped for four consecutive weeks to the lowest rate since June. As this pace, the drop in refinancing would eliminate $1 billion to $2 billion in annual savings for borrowers, Credit Suisse estimates. That's $1 billion to $2 billion that consumers won't have to spend on other things—plus whatever cash they might have taken out of their home equity when they refinanced. A drop in refinancings, you might conclude, is bad for economic growth.
- Lower bond prices will make life hard on anyone who has to sell bonds or a bond fund to pay for a college education or to pay for retirement. Investors who followed conventional wisdom and moved to shorter and shorter maturities as they got closer to the deadline for needing the cash will be OK. Investors who got greedy after the bond rally in 2009 and moved toward longer maturities to maximize their potential profit got burned. Bond managers who bet that the Federal Reserve's $600 billion in quantitative easing would lower yields on the seven- and ten-year bonds that the Fed had targeted have delivered a loss to their investors. In fact, a good part of the speed of the recent fall in bond prices is a result of bond pros selling in order to reverse the buys they put on to bet on the Fed. Investors who pile into bonds in 2011 because the asset class did so well in the first part of 2010 are just asking for losses, in my opinion.
- A rout in the bond market will be good for the stock market. If bond yields were already high, bonds would be competing with stocks for cash. Established high interest rates aren't good for stock prices. But rising yields produce falling bond prices that scare money out of bonds and bond funds. Some of that money will go into the safety of certificates of deposit and savings accounts. But have you looked at what these vehicles are paying? A good portion of the cash coming out of bonds will go into stocks.
- The same dynamic, in my opinion, applies to gold and other inflation hedges that don't pay a yield. If bond rates were already high, that would hurt gold prices because the forgone income from holding gold would, for some investors, outweigh the value of gold as a safe haven. But rising yields produce falling bond prices that create fear and uncertainty are a net positive for gold and other safe-haven plays. (For more on what's driving gold higher, see my post "With inflation on a run, the Chinese are buying gold, too.")
- For banks that borrow short and lend long, rising interest rates at the seven-year and longer maturities will produce higher profits. But the commercial paper market still hasn't recovered from the global financial crisis, and not all banks have access to that kind of short-term financing. I think it's fair to say that the rich banks will get richer and the poor banks will find it harder to keep up.
- Corporate chief financial officers have been working as hard as squirrels in October to put away a hoard of cheap money while it was available. Rising interest rates are largely irrelevant—for 2011 anyway—for many US companies, because they used bond offerings in 2009 and 2010 to pre-fund their investment plans for 2011. According to data from the Federal Reserve, at the end of the third quarter, companies had $1.93 trillion in cash and other liquid assets. That's a record nest egg.
- Consumers won't see much change in credit card or home-equity interest rates—initially. Most floating credit card rates are linked to short-term benchmark rates such as prime or LIBOR. Those rates won't be headed up until the Federal Reserve reverses its policy on holding short-term interest rates near 0%. And right now I don't expect such a reversal in 2011. But banks and other lenders have been known to use the cover of climbing rates somewhere on the yield curve to raise what they charge for money. If rising interest rates become Facebook and blog chatter, then banks will start raising rates on consumer credit.
- Bond mutual funds become a whole lot less attractive than bonds themselves when interest rates are climbing. If you own a bond, you can always hold to maturity. That way, whatever hit the price of the bond might take from rising rates doesn't matter to you because you get your original capital back when the bond matures. Bond funds, on the other hand, hold a portfolio of bonds that never matures. The portfolio continues to take a beating as prices fall. If you don't know how to build a laddered bond portfolio, now is the time to learn. And if you don't have a TreasuryDirect account that lets you buy Treasurys directly from the government, saving commission costs, now is the time to open one.
- Higher interest rates are ultimately one way that the financial markets can nudge the US government back toward fiscal sanity. As interest rates go up, the government has to pay more to service its debt, and that will end the free ride that Washington is getting on the national debt. With interest rates falling and then stabilizing at very low levels, Washington was actually able to reduce the cost of the country's debt even as it piled on more debt.
That period is coming to an end. Politicians will face an increasingly unpleasant choice among 1) actually reducing the debt, 2) forcing taxpayers to pay higher taxes to service the debt, or 3) enticing overseas investors to buy more debt so that the government can pay the interest on the existing debt. I'm pretty sure that our politicians will go for alternative number 3 for as long as they can. But overseas investors won't be willing to fund a Ponzi scheme like that forever. (And we all know how politicians feel about alternative number two these days.)
The mutual fund Jubak manages, Jubak Global Equity Fund (JUBAX), may or may not now own positions in stock mentioned in his columns. For a full list of the stocks in the fund as of the end of the most recent quarter, see the fund's portfolio here.
Jim Jubak has been writing "Jubak's Journal" and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of a new book, The Jubak Picks, and he writes the Jubak Picks blog. He is also the senior markets editor at MoneyShow.com.
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