Let's Buy Bonds...But Not for Long

06/11/2013 9:45 am EST

Focus: STRATEGIES

Jim Jubak

Founder and Editor, JubakPicks.com

It's been a scary six weeks for holders of fixed-income assets, and the long-term outlook isn't great for stocks, either. But the recent sell-off was extreme, so we could see a short-term rally in Treasuries, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

If all the recent talk from Federal Reserve members about plans to taper off the central bank's program of Treasury and mortgage-backed debt purchases was designed to test the temper of the bond market, the results have been nothing short of scary.

In the last few weeks, the Fed has discovered that when the bond market starts to worry about the end of the stimulus program and begins to unwind its long positions, there are few buyers for bonds or mortgage-backed securities. And when there are few buyers and everybody wants to sell, bonds drop like a stone.

We've all been worried that when the Fed starts to unwind its stimulus of the financial markets, it could set off a market rout. We—and the Fed—have discovered that we were right to worry.

And now the question is, What can the Fed do to stem a drop in bond prices that is definitely too far and too fast?

That's an important question for bondholders, obviously, but also for investors in stocks. Some volatility in bonds will move some investors into stocks. But too much volatility in bonds is simply scary and sends money rushing out of all financial assets.

Bondpocalypse Now
Bonds have had a terrible six weeks. Treasuries—remember that they're used as a benchmark for risk-free return—have lost 10.7% from April 30 through the close on June 7, as measured by the Bloomberg US Treasury Bond index.

Other debt instruments, such as mortgage-backed securities, have had an even worse period. The iShares FTSE NAREIT Mortgage Plus (REM) exchange traded fund, which tracks REITs that buy mortgage-backed securities, declined 12.8% from April 30 through June 7. Annaly Capital Management (NLY), a REIT that manages a portfolio of mortgage-backed securities, was down 15.4% in that span.

Even the mighty have taken their lumps. The Bond King, Pimco's Bill Gross, has seen one of the funds he manages, Pimco Corporate and Income Opportunity (PTY), fall 13.5% from April 30 to June 7.

The drops seem extreme, unjustified, overdone, hysterical. After all, while the worry is that the Federal Reserve will start to taper off its monthly $85 billion in purchases as early as its June or July meetings, in reality the Fed hasn't done a dollar of tapering yet. A September or October schedule for any move seems more likely.

And even then, the Fed isn't likely to move especially rapidly. The yield on the ten-year Treasury has only gone up to 2.17%, from 1.84% a month ago and 1.64% a year ago.

But the drops don't seem extreme, unjustified, overdone, or hysterical at all when you consider the certainty that the Fed will move to withdraw stimulus from the financial markets sometime in late 2013 or early 2014—unless the US economy tanks. That will send interest rates higher. And bond prices lower.

Given that certainty, it's hard to figure out why anyone would buy bonds or other fixed-income securities at all. Yields are unattractively low, and prices are only headed lower in the long term. So why buy?

The drops we're seeing in the Treasury, corporate, and mortgage-backed markets are, from this perspective, exactly what you'd expect when a market begins to unwind huge long positions and finds that there aren't many buyers.

Think about it this way: an increase in the yield on the ten-year Treasury to 2.5% from today's 2.17%—certainly not inconceivable when the yield on the ten-year Treasury has gone to 2.17% from 1.84% in a month—would produce a drop in the price of a $1,000 Treasury to $868. That's an additional 13.2% loss. On top of the 10.7% loss that the Bloomberg Treasury index shows over the last six weeks.

For the risk of loss of capital of that magnitude, a Treasury buyer is currently getting paid 2.17%. That seems like an insane bet. It's a wonder that there are any buyers.

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What Could Turn This Around?
In the short term, I can think of three things-and they would probably wind up working in concert.

First, the yen could stop rallying against the dollar. When the yen was falling, money flowed into dollar-denominated assets, including Treasuries, because the dollar provided a safe haven from the decline in the yen. The extreme liquidity of the Treasury market—it's so big that it's easy to move in and out even if you manage huge positions—added to the attractiveness of the market as a safe haven.

On Friday, June 7, the dollar stopped its fall against the yen, and on June 10 the greenback rebounded, climbing 1.6% against the yen. After the dollar's fall against the yen, the currency has enough headroom against the yen—a move from Friday's close at 97.56 yen to the dollar to the top of the pre-rally range near 103—to make buying Treasuries an attractive bet on a rising dollar.

Second, the drop in Treasuries, mortgage-backed securities, and other debt instruments has been so fast (an 11% decline in Treasury prices in six weeks is huge for the bond market) that betting on a bounce is now attractive.

You don't have to believe in Treasuries as a good buy over the next six months to believe in buying them over the next few weeks. Especially if you're willing, as I would be, to bet that the Federal Reserve, surveying the carnage, is likely to start talking up the bond market both in public speeches and in conversations with market makers in Treasuries.

I think you're likely to hear a spate of commentary as a result of those Fed comments that say a decision to taper off asset purchases is off the table for the Fed's June and July meetings. (The Fed doesn't meet in August.) That talk will work to orchestrate a bond-market bounce.

The bounce is likely to be even bigger in the market for mortgage-backed securities, since the Fed is even more motivated to support this market. Much of the Fed's efforts in the most recent round of quantitative easing have been directed at the mortgage market, and I think the Fed will do all it can to preserve the hard-won gains in the housing market.

And third, the bond market, once its near-term panic subsides for the reasons cited above, is likely to realize that fundamentals for bonds aren't terrible.

The weak first-quarter GDP numbers in the United States now look likely to be followed by weak second-quarter growth. But that weak growth doesn't look so weak that it will lead to a big surge in defaults in the corporate high-yield-bond market (aka junk bonds) from current historically low levels.

Also, there's not even a whiff of inflation in the United States. The Fed's preferred inflation indicator, the Personal Consumption Expenditure deflator, rose at a tiny 0.7% annual rate in April. That low rate of inflation means that even at 2.2% or so, the real yield on ten-year Treasuries (that is the yield after subtracting inflation) is the highest in two years.

Good for Stocks
All of this argues for a bounce, followed by some stabilization in the bond market over the next few weeks and maybe even into the fall. (Then we can start worrying about a possible tapering off in the Fed's purchases of Treasuries and mortgage-backed securities, starting in October.)

A lack of panic in the bond market would be good for stocks as well. But...a bounce and stabilization won't change the longer-term picture. What we've learned about the bond market in the last six weeks isn't especially reassuring.

Once the market becomes convinced that the Fed is on the verge of tapering off its purchases, the rush for the door is massive and disorderly. Buyers become few and far between, and losses, especially in terms of the usual volatility of the bond market, are scarily large.

Any short-term rally in bonds shouldn't lull you into complacency about the risks to your bond portfolio.

We've had a dry run at what this market will look like in the event of selling on a belief in Fed tapering. It has been really ugly. Even if bondholders get a respite from the damage, they should use it to reduce the risk from bonds in their portfolios.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. For a full list of the stocks in the fund as of the end of March, see the fund's portfolio here.

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