Should You Avoid Bonds?

SUMMARY:

Bill Gross warned investors to watch for the 10-year Treasury yield to exceed 2.6% as a signal that a bear market in bonds had begun. Here we go with another bond market scare, just like the wrong one of 2013 known as the taper tantrum.

Market history shows that a rising rate environment causes a short-term bond-price dip only, and that account balances soon recover as distributions rise and bond prices rebound.

More important, if you’re worried about what interest rates and yields will do to your bond funds, you’re investing the wrong way. Do what I do: Use bond funds as a repository for stock-market buying power, then you’ll benefit from changing prices on both sides of the equation.

TRANSCRIPT:

Hello, I’m Jason Kelly. Thank you for joining me.

Should you avoid bonds?

Ever since the taper tantrum of summer 2013, investors have worried about a bond crash.

Last week brought a fresh warning from bond guru Bill Gross at Janus. He says to watch the 10-year Treasury yield for signs of a bear market in bonds, and believes crossing above 2.6% will be the signal.

Bond prices and yields move in opposite directions, so a rising yield will indicate falling prices.

Let’s get some perspective. Take a look at this chart.

This shows the 10-year Treasury yield over the past five years. It spiked above 2% in 2012, then settled back to 1.6%.

The surge to more than 2.6% in 2013 that lingered into 2014 was the taper tantrum.

Now, the taper tantrum was kicked off by then-Federal Reserve Chairman Ben Bernanke saying in spring 2013 that the central bank might cut the pace of its bond purchases, or “taper” them, and that’s what sent yields soaring.

This Bloomberg story dated May 23, 2013 captures the tone of that time.

Notice that exceeding just 2% was considered headline worthy at the time. Nobody could have known that the yield would rise all the way to 3% by the end of December 2013.

Now, what was Bill Gross saying back then? He warned that low interest rates could persist for a long time because the economy was bad.

Two years ago, with the yield back down below 2%, he wrote that “The good times are over.” Bearishness at that time was laced with references to falling yields, falling stock prices, and falling oil prices.

But, the Fed didn’t raise interest rates until December 2015, then again in December 2016. The taper tantrum of 2013 was premature, which is often the case, as you’ll see in a moment.

Even after interest rates rose, did bonds crash? No.

Look at BND, the Vanguard Total Bond fund.

As yields soared in the taper tantrum, down went bond prices. As yields soared after the election and rate hike last December, down went bond prices.

But, look at the event in the middle. The Fed’s first rate increase happened just before that price spike. Shouldn’t the yield have risen along with the Fed’s key rate, and shouldn’t prices have gone down? That’s conventional wisdom, but it didn’t happen. So who’s to say what will happen next?

Nobody can know what action the Fed will take, nor when, nor how bonds will react to that action.

Even more important, bond investors should not fixate on price change. Why? Because most of a bond fund’s total return, that is overall profit, comes from distribution payments, not price change.

If you need money from your bonds right away, you should be in a bond fund that doesn’t fluctuate much: a short-term bond fund.

If you don’t need the money soon, it can keep collecting distribution payments through short-term price volatility and come out ahead over time.

This makes sense, right? If yields are rising as prices fall, eventually the payouts from bond funds will rise, too. Bond funds will acquire newly issued, higher-yielding bonds, so their payouts will rise. The key is, you need time.

Rob Williams at Schwab looked at this phenomenon in a paper he published last November. He found, quote:

“In the past three cycles, the six months just prior to and few months just after the first rate hikes were the most volatile. Markets, after all, are forward looking. They often try to anticipate future moves in fundamentals — for example, interest rates — in advance. After the initial rate hikes, prices stabilized or recovered, and income payments gradually helped returns rise.”

Now, this is exactly what we’re talking about here. Notice, for example, how bond funds of various categories fared following the rate-hiking environment of 2004 to 2006.

Rates rose from 1.25% to 5.25% in 25 months. Following the rough patch in the beginning, all bond funds recovered just fine. This is probably how it will go in the current cycle as well.

Now, in addition to making sure you’re in the appropriate type of bond fund for your time frame, I recommend that you use bond funds the way I do in The Kelly Letter: as storage for safe capital used for buying the stock market during down periods.

My signal system either buys or sells stocks once per quarter. If it sells, the proceeds go into a bond fund. If it buys, the money comes out of the bond fund. This means that both sides of the equation can benefit from fluctuating prices, and that investors don’t need to fret over whether now is a good or bad time to own either asset class.

Just run the system. It’ll react appropriately to whatever the dual price lines do.

So, should you care whether the 10-year yield hits 2.6%, the way Bill Gross suggests?

No.

If you’re worried about what-ifs like that, you’re investing the wrong way.

Use bond funds the right way and you’ll never have to care where rates are going — which is good, because nobody knows.

If you’d rather not think about how to run bonds the right way, and just want to begin an automated system that manages them for you, consider joining The Kelly Letter.

I’ll get you all set up to run the signal once a quarter, and start beating the market with no stress from indecision.

To learn more about the letter, please visit jasonkelly.com.

Have a great weekend. Kelly Letter subscribers, I will see you Sunday morning.

Thank you for watching!


For more punditry gone wrong, see the Z-Val Zone Stock Market Forecasts page.

To check the performance of my stock/bond signal system, please visit my Strategies page.

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