Bond prices have soared in 2014, with the iShares 20+ Year Treasury Bond ETF (TLT) jumping more than 8% since January as the stock market has slumped for a small decline.
Click to Enlarge The rally in bond prices and the drop in interest rates on the 10-year Treasury bond have surprised some investors. After all, it’s a bit counterintuitive to see interest rates declining even as the U.S. Federal Reserve talks about the likelihood of tighter monetary policy and higher interest rates in the next year or so.
So what gives … and more importantly, can the rally in bond prices last?
The short answer is that a selloff in the stock market and fears of unrest in Russia (and elsewhere) have driven investors into the safety of bonds. But this near-term trend cannot continue for long, and investors should expect a correction in bond prices very soon.
Bond Prices and Yield – What’s Going On?
Here’s some investing 101 about bonds, in case you’re unfamiliar:
As yields increase, the principle value of bonds falls. This is logical: Why would you pay the same amount for the face value of a bond with a 3% yield when you can get a similar note from a similar government or corporation at a 3.5% or a 4% yield? The old debt is simply not as attractive, so bond prices fall as a result.
On the other hand, when new debt is offered at a lower interest rate, the older bonds with higher yields are naturally more attractive — and investors are eager to buy them, driving up the prices.
This doesn’t affect you if you hold bonds to duration and expect a regular stream of income, with no plans to sell these bonds. However, many investors don’t own individual bonds and are instead in long-term bond funds that regularly buy and sell their holdings — exposing investors to a loss in principle if rates rise.
Given this relationship between bond prices and yield, many investors have been worried about holding long-term bond funds like the TLT ETF or mutual funds, including the PIMCO Long Duration Total Return Fund (PLRIX) or the Vanguard Long-Term Bond Index Fund (VBLTX). Rates are expected to rise, and these funds are the most exposed to interest-rate risk given the very long duration of their holdings.
But Treasuries have rallied sharply to start the year, partly because of political strife between Russia and Ukraine. Similarly, the roaring rally for equities in 2013 seems to have lost steam with the S&P taking a breather. Many investors have gone “risk off” as big names from Amazon (AMZN) to General Motors (GM) to Best Buy (BBY) have all sold off more than 20% since Jan. 1.
Throw in the Fed’s Janet Yellen seeming to backpedal on the timing of rate hikes, and you can understand why investors have been buying more bonds, sending rates dipping as a result.
Why You Should Sell Bonds Now
Now, if you own bonds to duration or if you’re an income-oriented investor who relies on your monthly coupon payments to pay the rent, I wouldn’t read too much into the recent volatility. After all, your portfolio is designed to “pay” you with your bond income — not to make a lot of dough based on principle increases.
However, if you’re younger or more aggressive with your holdings and don’t rely on bonds for income, it might be wise to sell some bonds and bond funds now that yields have rolled back and prices are high.
Because frankly, this can’t last. Bond prices and yields will both reverse course as the U.S. continues its slow and steady economic improvement, and the Fed continues to slowly tighten monetary policy and end QE.
Simply ask yourself, “How much lower can interest rates realistically go?” Barring a shock to the market like a terrorist attack at home or a market meltdown that sparks a massive departure from stocks, I remain convinced rates are at or near as low as we’ll see them for some time.
After all, 10-year U.S. Treasury bonds yield yielded 3% at the end of 2013 just a few months ago. Even making back half of that ground would result in a pretty modest hit for long-term bond funds.
I would advise taking some money out of long-term bond funds right now and waiting for the inevitable pop in yields before rotating back in. Or if you really want to be aggressive, consider shorting bonds via an inverse bond fund like the ProShares Short 20+ Year Treasury ETF (TBF).
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. Write him at email@example.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not hold a position in any of the aforementioned securities.