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Bonds

U.S. bond bulls not ready to call off the charge Add to ...

They are the few, the brave, the unloved, and among big investors, their number shrinks by the month.

They are the last of the bond bulls, the investors who believe long-term U.S. government bonds will extend a historic run that has already pushed interest rates to multi-decade lows.

Recent surveys show broad disdain for Treasuries among market cognoscenti. A cross-section of star money mangers and investors, including Warren Buffett, BlackRock’s Larry Fink and even bond expert Dan Fuss of Loomis Sayles, have urged investors to switch to stocks, arguing yields have nowhere to go but up.

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Yet the average retail investor keeps sending money to bond funds. And in the past few weeks, things have been moving in the bond bulls’ favor.

Fear of a Greek exit from the euro zone and JPMorgan Chase & Co ’s unexpected $2-billion (U.S.) trading loss have ignited a rush out of bank stocks and other risky assets and into low-yielding Treasuries, sending the benchmark 10-year yield to 1.78 per cent.

That has helped the Barclays Capital Treasury index, which rose 9.81 per cent last year, erase early 2012 losses, while S&P 500 ’s gains have been halved since peaking in April.

The most bullish bond investors are betting the yield on the 10 year will tumble to 1 per cent before it hits bottom.

The case for Treasuries, they say is a simple one: with Europe in recession, China’s economy slowing and hopes of robust U.S. growth fading, the global economy is simply too weak to stoke significant inflation or justify higher interest rates.

“With all the uncertainty in the world, it’s nice to hang your hat on something you can be sure of, which is that there is virtually no interest rate risk to owning bonds for the next several years,” said David Rosenberg, chief economist and strategist at Gluskin Sheff, which manages about $6-billion.

Indeed, Federal Reserve Chairman Ben Bernanke has all but promised that short-term borrowing costs, pinned near zero since 2008, will likely stay there for at least another two years.

“Look at it this way: the Treasury market is like a casino,” says Robert Kessler, a Denver-based fund manager who runs Treasury-only portfolios for rich investors and institutions. “And the head of the casino is telling you that you can’t lose as long as you keep playing in his casino.”

Treasuries certainly were a gold mine for investors in 2011, when the U.S. economy grew just 1.6 per cent.

The S&P 500, meanwhile, provided enough volatility to make even the most seasoned investor dizzy, only to end the year where it began for a total return of just 2.1 per cent, including dividends..

Mr. Kessler, whose fund earned clients 6.1 per cent in 2011 and 7.85 per cent in 2010, said he expects 10-year yields to hit 1 per cent, while Mr. Rosenberg expects the 30-year yield, trading just below 3 per cent, to end the year closer to 2 per cent.

Depressed economic conditions and elevated anxiety have a lot to do with Treasuries’ recent stellar performance.

So has the Fed’s quantitative easing policy, an attempt to lower long-term interest rates and revive the housing market by purchasing $2.3-trillion of Treasury and mortgage-backed debt.

But doubters say 2011’s gains look like the last gasp of a 30-year bull run, made possible by a steady decline in inflation.

Between 1981 and 2011, government bonds with maturities of 10 years or more provided an average total return of 11.4 per cent, according to Standard & Poor’s data.

That puts them neck-and-neck with the S&P 500 index, which returned 11.9 per cent for the period, and well ahead of bonds’ 85-year average of 6.2 per cent.

“That kind of performance is just not repeatable for another 30 years,” said Dean Junkans, chief investment officer at Wells Fargo Private Bank, who prefers dividend-yielding stocks, high-yield corporate bonds and emerging market assets to Treasuries.

At some point, bond bears say, interest rates will have to rise as quicker growth stokes inflation, making government debt a terrible place to be.

“The minute we start to see yields rising and prices falling, we’ll see a substantial exodus from bonds,” said Jeff Sica, chief investment officer at Sica Wealth Management, which oversees $1-billion.

For a few weeks in March, it looked as if the exodus had begun. Several months of firmer economic data pushed stocks to a four-year peak and sent yields sharply higher.

But more recent data has been less impressive: the pace of hiring has slowed, keeping the jobless rate high, real incomes remain stagnant and household debt levels remain high.

“We’re looking at very difficult conditions, not only in the U.S. but worldwide,” said Lacy Hunt, chief economist at Hoisington Investment Management, which oversees $5.8-billion in fixed-income assets for institutional clients.

“Our view is long rates are low and likely to go lower because of poor economic conditions.”

The Wasatach-Hoisington U.S. Treasury mutual fund was down 3 per cent through April 30 after gaining 41.2 per cent in 2011.

Some indicators suggest there’s more conviction behind bonds than stocks. While the first quarter was the best for the S&P 500 in 14 years, trading volumes were off more than 10 per cent from a year earlier, suggesting few new buyers were jumping in.

U.S.-domiciled taxable bond funds, according to Thomson Reuters’ Lipper data, have pulled in $137.58-billion so far this year after attracting $178.24-billion in 2011. Equity funds have reported a $24.09-billion inflow in 2012, after suffering an outflow in 2011.

What’s more, the days when stocks dominated U.S. investment portfolios – what Citigroup strategists call “the equity cult” – may be coming to an end.

In the early 1950s, U.S. private sector pension funds held just 17 per cent of assets in stocks and 67 per cent in bonds, Citigroup noted. But a decade of strong performance changed that, and by 2000, those percentages had switched.

Over the next decade, though, equities underperformed bonds. By Citigroup’s estimate, inflation-adjusted U.S. equity returns were a miserable -3.5 per cent, while bonds returned 4 per cent. That has caused the pendulum to start swinging the other way again, as pension funds and retail investors increase bond holdings.

“The 1990s represented the peak of a 50-year investor shift away from bonds to equities,” the strategists write. “At just 12 years old, the shift back the other way still looks immature.”

Some worry this means that investors, by immunizing themselves against past risks, are foregoing future opportunity.

“I’ve been asked what keeps me awake at night, and it’s that people’s portfolios are perfectly positioned for the past,” said Art Steinmetz, who directs management of $177-billion in assets as chief investment officer at Oppenheimer Funds in New York.

“I’m completely sympathetic to their fears ... We’ve had a decade when stocks have performed very poorly. But I’m worried that people who got whacked on equities are going into fixed income and are going to get whacked on fixed income.”

Societe Generale strategist and 15-year bond bull Albert Edwards understands that view but warns it’s still too early to abandon Treasuries.

Over the next 12 to 18 months, he predicts that a new U.S. recession and a severe slowdown in China will push 10-year Treasury yields to 1 per cent and spark a sell-off in equities.

“We understand what the pessimists are saying. Over the next five to 10 years, government bonds will prove to be a terrible investment,” he said. “But in the near term, if China hard-lands and the U.S. goes back into recession, I think people will look at a 1 per cent yield and consider it a fantastic place to be.”

 
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