I read an article this morning on CNBC.com about the asset allocations people are making into longer- term bond funds. I must admit, I was somewhat frightened after reading it. The portfolio manager interviewed did not believe the bond investors’ motives were sound, but he claimed the massive inflows into bond funds basically came from two camps.
First, since money-market returns are basically zero, people are moving money into longer-term bond funds in order to improve yield. The second reason was around the fact that risk managers are forcing more long-term allocations into “risk-free” asset classes.
The fact of the matter is that there are risks to long-dated Treasury bonds. Now, because the U.S. government can print more money, it will be highly likely to meet its obligations on the bonds. This is true. For example, if an investor buys a 30-year bond with a 3.75% coupon and yield to maturity, he or she will likely get the coupon and the principal over that time frame. However, this depends on the investor committing the money for the next 30 years. Right now, rates are at historic lows because prevailing views around the economy are that the recovery will be weak for the extended future.
If for some reason that changes 12 months from now and inflation expectations come back to the marketplace at an annual rate of 4%, an investor holding a 30-year bond with a yield of 3.75% will be receiving a “real” return (basically defined as the return less the inflation rate) of NEGATIVE 0.25%. That is not good.
If the same person had invested in a one-year T-bill at 25 basis points, the return in the first year would have been paltry, but he or she would have been free to re-invest the principal for the remaining 29 years at the new market rate, which in the current scenario would almost certainly be much higher.
The 30-year bond that was bought at 3.75% would face a large price drop if inflation expectations went to 4%. As bond yields rise, bond prices decline, and this price drop would be reflected in the investor’s account, which would subsequently be marked lower. There is not re-payment risk in this situation but there is definitely price risk. The fact of the matter is, the longer-dated the bonds are, the greater the price risk. The longer the holding period, the longer it is before investors can get their principal back and potentially re-invest at a higher rate.
All investors should realize that if they buy long-dated bonds, they are opening themselves up to a large price decline in the event that there is a change in expectations around the U.S. economy and inflation. There is also risk around the amount of debt the U.S. government is taking on.
As the country takes more and more debt onto its balance sheet, people could demand a larger return because of the risk of their money getting repaid with dollars that are still worth something. The government can theoretically print the money and repay the bonds. However, if it prints a ton of money, then the value of the U.S. dollar – compared to other currencies and especially hard assets (such as gold, wheat, oil) – will more than likely be much lower. The principal the investor will receive would be worth much less than when he or she bought the bonds.
I am not trying to call the top in the bond market. If you feel the economy will be weak for a long timeframe, and that inflation will be virtually zero, a yield of 3.75% (or higher for corporate debt) probably makes a lot of sense. However, if for some reason you think, just because they are debt instruments, that long-term bonds don’t have price risk, you could be in for a very rude awakening.
There are equity and options trades that could generate attractive yields compared to bonds. An investor would definitely take on equity price risk, but it may be worth considering. Customers could buy stocks with high dividend yields. To add to that yield, they could overwrite calls on those stocks.
Investors who are extremely worried about the downside could buy the stocks to collect the dividend and look at putting on collar strategies around them. Collars entail buying a downside put and selling an upside call. In this trade, the downside risk is mitigated with the put, but the upside is capped by selling the call. Stocks can also be negatively affected by increased inflation expectations, but it is not necessarily the case. You can also do these equity trades in sectors that might actually benefit from inflation, such as oil or agriculture. Bonds, by definition of their fixed return, suffer more from increases in anticipated inflation.
Photo Credit: woodleywonderworks
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Tags: Bond Yield, bonds, Collars, Investing, T-Bills, Treasurys, U.S. Treasury
