September 9, 2013

Bond price erosion: Is the tide going out or coming in?

There is turmoil in world financial markets as late summer comes to 2013. This time, the problems aren't stock prices but falling bond prices. What is going on and should investors bail out?

The long-term averages should give comfort to investors, as bond prices often move in opposition to stock prices and provide a balancing-out effect, or a diversification benefit. Bonds have been a great tool to have in one's possession during recessions. But this is a period of US growth, and we’re seeing rising yields and falling bond indices. Where do we go from here? What do we do now?

Right now, we are seeing slightly better growth in the United States, and bond prices have fallen. Since late May, the price of the 10-year benchmark Treasury bond has fallen more than 5%. This loss has shocked many investors, who had come to see bonds as impervious to the sharp drops we associate with stocks. During the same period, stock prices have actually risen overall, by almost 1%.

Bond yields seem to be driven over long periods of time by a combination of economic growth and inflation. Both growth and inflation play a role in driving bond prices down and yields up. These are the risks to bond holdings, because growth brings "opportunity cost" and inflation means erosion of buying power. When bond yields go up bond prices go down. In general, this coincides with periods of growth.

This happens for two simple reasons: 1) Economic growth brings other opportunities for returns, drawing money away from the bond market; 2) Growth can, but does not always, bring inflation, which erodes the buying power of money tied up in bonds. And that pushes down their price and pushes up their yield. Currently, in the summer of 2013, it is growth alone, not inflation, that is causing bond prices to fall.

The prevailing idea of bonds as a “safe” investment probably comes from two notions: First, if you buy a bond and hold it to maturity, and if the bond issuer is still in business, you get your money back plus the stated return. The problem with this type of thinking is that in the meantime inflation can rob you of some buying power because interest rates can rise and you are unable to put your money to work at a higher rate elsewhere. This is the double whammy of opportunity cost and inflation risk.

The second reason that people consider bonds a safe investment is that for more than 30 years the trend in interest rates has been largely downward and prices of bonds have been rising year over year for those decades. Bond portfolios show mostly positive returns for those three decades. It is hard for investors to remember a time when bond strategies were losing strategies. But market regimes don’t last forever, and we could be seeing a change in market direction.

Take 1994. This was the most infamous break in this thirty- year benign period for bonds. That year, the US Federal Reserve began to move quickly to tighten monetary policy and set out to increase the cost of short-term borrowing. There was a dramatic decline in bond prices in response. Some bonds lost more than 12% in value. But 1994 was an isolated event, and memories faded within a couple of years.

So far, in the summer of 2013, the fall in bond prices does not yet match the drop of 1994, so this is not a historic event of that proportion.

Why 2013 is different: This summer, it is economic growth and the direction of the US central bank that is at the heart of bond malaise. Since the last recession four years ago, bond yields and therefore bond prices have been restrained. This is the result of quantitative easing, the Fed’s bond-buying actions. This program of buying bonds and putting upward pressure on bond prices is now about to be slowly phased out. Thus, the Fed’s market intervention is slowly giving way to the forces of the market. And price discovery, a process of free markets finding a proper equilibrium in price versus risk, is now occurring. The market seems to be saying that US growth is on the move and bond yields should be higher and bond prices lower.

What to do now?
  1. Keep some bonds as insurance. Recessions have not been abolished and the timing of their return is not totally predictable. In advance of recession, riskier assets such as stocks fall, and high-quality bond prices rise. Bonds are still a sensible insurance policy against the ravages of the business cycle. Keep some bonds in your portfolio for recession insurance.
  2. Appreciate the value of income. Steady income is still hard to obtain in these markets and deposit rates are not likely to rise soon, so income generation is still a commendable goal for both compounding of interest and for supplementing current income. Bonds are not obsolete for these two uses.
  3. Select the right type of bonds. Price erosion in rising growth environments is worse in longer-duration and higher-grade bonds. Baskets of shorter-maturity bonds are a sensible way to limit bond price erosion.
  4. Consider extra yield without too much risk. Combine credit with short maturities. The long-term record of high-grade credit bonds in providing more income, adjusted for some losses and lack of liquidity, helps offset the risks of government bonds (the highest quality of bonds). A carefully selected basket of corporate or similar bonds with shorter maturities, sifted through by analysis, can be a good tool for providing a portfolio both ballast and extra return.
The current bad time for bonds will be ended some day by a period of reprieve as slowing economic data come in and bond prices regain their footing. This is a constant process. Economic growth will then accelerate for a while and/or inflation will return, and bond portfolios will lose ground once again. The overall idea is that until the next recession growth will win out and the Fed will slowly move to stage left. These events will leave bond investors vulnerable to gradual or successive price erosions.

It is best to manage bond price erosion with some common sense and never give up on the idea that recession insurance, or ballast is a good thing. Regardless of other considerations, bonds still serve as such.

No forecasts can be guaranteed.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.


No comments:

Post a Comment

We look forward to hearing from you about James' commentary and perspective, but please read our commenting guidelines first. James and MFS are hopeful that your feedback will provide insight for future blog entries. Questions or comments about your MFS investments or customer-service issues? Please contact MFS directly.