SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds

Subscribe via email

Grab our RSS Feed

Will the bond rally last?

Looking at the chart above, it quite obvious that bonds have outperformed stocks in 2010. The S&P 500 (red line) is down 2 percent while TLT, the ETF for long-term bonds (blue line) has rallied 17 percent since the start of this year. The spectacular bond rally in recent weeks has become the hottest topic in the financial headlines. Bond yields which move inversely to bond prices have fallen to record lows.  The yield for the US 10 year bond fell as low as 2.58 percent this week and many financial experts are scratching their heads and cannot understand why investors would be happy to accept such low returns and think this rally is just a bubble which will soon burst. In my humble opinion, I don’t think the bond rally is a bubble as there is a huge demand for bonds for some time to come.

Baby boomers, the largest group of investors are reaching the age where their risk tolerance is low. Their financial advisers would be advising them to change their portfolio allocation to a more conservative one which has a higher allocation to fixed income. From mutual fund data, money has been flowing out of equity funds and into bond funds. The amount of money entering bond funds even exceed money leaving equity funds, meaning that new savings are going into bond funds. The US savings rate has gone up to 6 percent and I would argue that a lot of the savings are coming from the “empty nesters” i.e. baby boomers who are still working and earning good income but have reduced expenses. From a US investor’s perspective, there are few better investment alternatives to bonds. Property prices have fallen since 2006 and are still continuing to fall so there is little reason to invest in property. The stock market is still 30 percent below it’s value in 2000 and investors in this age group would have endured two stock market crashes where their stock portfolio have fallen by up to 50 percent each time so I don’t think many people approaching their retirement would want to risk putting their nest egg in an asset class that is so volatile. Bank interest rates in the US are near zero so cash is not an attractive investment option either. With over 100 bank failures in 2010, the FDIC which guarantees bank deposits is almost broke so keeping money in the bank is also not as safe as owning treasury bonds which are guaranteed by the US government. While a 2-4 percent return may not seem like much, it sure beats a negative return!

While the bond rally is a relatively new phenomenon in the Western economies, this has been happening for years in Japan whose citizens are on average 10 years older. Bond yields have continued to fall over the years and are still falling. The 10 year Japanese bond yield recently fell below 1 percent, making the 2.5 percent yield of its US counterpart look rich in comparison. Property and stock prices have also been falling since 1989 so even at 1 percent yield, bonds are still more attractive than other asset classes. If the US follows in the footsteps of Japan, bond yields still have a long way more to fall which means that the bond rally should continue for some time to come.

Individual investors are not the only ones who want to buy bonds. Banks who can borrow at interest rates of close to zero percent are also buying truckloads of bonds as the yields are very attractive especially when you can buy them using leverage. If you can buy $1 million worth of bonds using $100K of your own money and borrowing the rest at zero percent, a 4 percent yield would equate to a 40 percent return on your $100K. This type of trade has been responsible for the fat profits reported by banks. Banks prefer to buy treasuries rather than to lend money to people to buy risky assets like property or businesses.

On top of all this demand from investors and banks, the Federal Reserve Bank has also announced that it plans to buy bonds as well as part of its quantitative easing program. The Fed has deep pockets and can buy big – they bought over a trillion dollars worth of mortgage backed securities last year. On hearing this announcement, speculators like hedge funds are also jumping in to buy bonds as part of “front running the Fed”.

US treasury bears have always argued that the US will not be like Japan because unlike Japan most of the US government debt is owned by foreigners like China who will one day dump their US treasury investments when they get freaked out by the ballooning US debt. When this happens, they expect bond yields to go up just as they did in Greece and the other European countries with sovereign debt problems. Well, this scenario actually happened recently as China sold off over 21 billion dollars worth of US long term bonds in June 2010 and guess what happened? They were snapped up by domestic buyers and bond yields continued to fall!

I think the penny is finally starting to drop on what happens when there is deflation – quality bonds are still the best investments. Even Alan Kohler who for a long time has poo-poohed the “deflationeers” has advised his Eureka report subscribers this week to buy some bonds, just in case. Does Australia have a problem with deflation as well? The stock market is about 25 percent below its 2007 peak and like the US S&P 500, has gone nowhere in 2010. Since the new restrictions for foreign property investors were announced in April 2010, property prices seem to have plateaued and sales have slowed. I don’t know about you but it looks to me like deflation is coming, if not already here.

Leave a Reply