News

How did it all go wrong? If you're a bond investor, the question is: How did it all go right?

Stock market losses have been wearing on the patience of equity investors for more than a year, but in that same period bonds – in particular, U.S. Treasuries – have been going gangbusters. As prices have risen, yields (which move in the opposite direction to price) have fallen to historic lows, rewarding investors with wonderful capital gains in the process.

The difference in performance is best seen by comparing a couple of popular bond-specific exchange-traded funds with the S&P 500. In 2008, the index has plunged about 38 per cent, and that is after factoring in dividends.

But the iShares 1-3 Year Treasury Bond ETF – a fund that holds short-term Treasuries but trades on the New York Stock Exchange like a stock – has risen 6.4 per cent, after including distributions. Even better, the longer-term iShares 10-20 Year Treasury Bond ETF has risen 22.2 per cent, with most of the rise in the past month. Remember, we're talking about staid bonds here: That's an incredible 60 percentage-point difference with the S&P 500.

In other words, while equity investors have been singing the blues this year, bond investors have been whistling Zippity Do Da.

The reason for the incredible difference? Most of it comes down to the deteriorating U.S. economy, which has killed any threat of inflation (inflation is terrible news for bond investors) and put the U.S. Federal Reserve in an aggressive rate-cutting campaign, which affects the direction of bond prices and yields. At the start of the year, the Fed's key interest rate was 4.25 per cent; as of last week, it was more or less at zero.

At the same time, investors fleeing other assets, including stocks and commodities, have flooded into the relative safety of U.S. Treasuries – to the point where the yield on the 3-month Treasury bill recently fell to 0 per cent.

Yes, everything has gone right for bond investors over the past year. But what about the coming year? Some observers believe that the U.S. Treasury bond market is looking like the next in a long series of asset bubbles, suggesting that there is pain ahead for bond – and bond ETF – investors.

David Rosenberg, North American economist at Merrill Lynch, however, is simply toning down his enthusiasm. “After years of being super-bullish on Treasuries, we feel as though we are bidding farewell to an old friend,” he said in a note.

Either way, the chances of winning outsized gains in the coming months are pretty slim. Sometimes, when everything goes right for an investment, that's the best time to say adieu and move on.

See David Berman's Market Blog at ReportonBusiness.com