How To Profit From An Epic Bond Selloff…
If the stock market experienced a devastating 50% decline, it would provoke widespread panic. It would be headline news on every network and newspaper. Investors would be afraid to open their 401(K) statements.
Believe it or not, that’s exactly what happened to long-term bonds. And not risky emerging market junk bonds, but ultra-secure IOUs backed by the full faith and credit of Uncle Sam.
First things first, let me repeat the most basic and immutable law of bond investing: bond prices move inversely to interest rates. (They can also fluctuate with perceived changes in credit quality, but that’s a topic for another day).
While this may initially seem counter-intuitive, it’s a pretty simple concept. (feel free to skip ahead if you’re up to speed).
Suppose you buy a bond in 2020 that promises a 5% income stream until maturity in 2025. Then, six months later, prevailing rates for similar bonds suddenly sink to 4%. In that case, your 5% bond is clearly more desirable. Other investors would happily pay you a premium for it – so its value rises. And if rates keep falling to 3%, then the value rises even more.
The opposite is also true. If prevailing rates climb to 6% or 7%, the value of your 5% bond will be diminished. It would sell at a discount to compensate for the difference in projected income. Remember, inflation erodes the purchasing power of these fixed coupon payments over time. So, the longer until maturity, the greater the impact of rising rates.
Without getting into the math, it stands to reason that the value of a 10-year bond will swing considerably more than the value of a 1-year bond in response to interest rate changes. In technical jargon, this sensitivity is called “duration.”
While individual bonds can always be held until maturity, most investors gain exposure through mutual funds and ETFs, whose portfolio value fluctuates daily. Fund providers are kind enough to calculate the average weighted durations of their portfolio – the higher the figure, the more NAV (net asset value) can bounce around.
I Saw it Coming…
Normally, bonds are known for their stability – but these are not normal times.
Interest rates have soared over the past two years amid one of the most aggressive Fed rate tightening cycles on record. The relentless uptick in rates has made fixed-income investing perilous, to say the least. But some groups have been punished more than others. Few corners of the bond market are more susceptible than 30-year bonds. They feel the pain (and pleasure) from rate changes more acutely.
And the dividing line may be upon us.
Unless you’re a brand new reader, you’ve undoubtedly seen my repeated warnings about rate hikes. That started over two years ago, in May 2021, when inflation was taking root.
We all know the rest of the story. Inflation would continue to rise unchecked, eventually peaking near 10%. After dismissing the avalanche of data as “transitory” for nearly a year, the Fed was finally forced to concede its mistake and take action.
At that point, the central bank kept rates near zero while pumping billions into quantitative easing measures – despite key inflation gauges at 40-year highs.
But the switch was flipped on March 15, 2022. We saw the first rate hike in the campaign that day. And then another in May. And then two more in June and July. There have been seven more since then, nearly a dozen all told. Over this time frame, the influential Fed funds rate has been lifted from zero to between 5.25% and 5.50% — the highest level since 2001.
Source: Federal Reserve Bank of St. Louis
What Goes Up Must Come Down
When my first warning went out, the 10-year Treasury yielded 1.65%. It would soon top 2%, 3%, and 4%, finally peaking above 5% last month. This is a seismic change in a world where a few hundredths of a point is a fairly sizeable move.
Remember what we said about bond prices moving in the opposite direction of rates? Over the past 30 months, 10-year Treasury Bonds have lost over one-third of their value. And 30-year bonds, which are more sensitive to rate vibrations, have been cut in half — tumbling more than 50%.
In sheer percentage terms, that’s on par with the historic stock market meltdowns in 2000/2001 (the dot-com crash) and 2007/2008 (the financial crisis). By some measures, this has been the most severe bond bear market in the past two centuries.
Check out the ugly chart of the iShares 20+ Year Treasury Bond ETF (NYSE: TLT).
But the tide of the battle is turning. The Fed is now winning the fight against inflation. It took extreme measures, but the October CPI report showed the price growth for goods and services decelerating to just 3.2%, down from 3.7% in September. Many categories show outright declines, from school supplies to used cars to kitchen appliances.
It seems apparent that core inflation is creeping back down towards the Fed’s 2% comfort zone.
Inflation is a fire that must be completely extinguished and not left smoldering. But at this point, the bigger risk is that the Fed over-corrects. That’s why when tightening is over, it usually gives way to loosening rather quickly. Historically speaking, once rates peak, the next downcycle usually starts within four to six months.
That pattern will likely play out once again. In fact, a recent survey of Bank of America money managers found that 80% of respondents see bond yields falling in early 2024. That’s the highest conviction ever for this poll. These experts have never been so sure that bond yields are about to fall – which means they have never been this sure that bond prices are set to rise.
We could see a mirror image of the past two years. From tight to loose… restrictive to accommodative… bear market collapse to bull market rebound.
And the back-end of the yield curve that was the most punished will have the most to gain.
The best time to invest in equities is usually at the tail end of an epic rout. The same is true of bonds. And since this pullback has been one for the record books, the recovery could be just as powerful.
But the window of opportunity to lock down these elevated yields – potentially sweetened with rare capital appreciation – is about to slam shut. It may be closing as we speak, considering the long bond yield has already retreated from above 5.0% to a recent 4.6%.
Over at High-Yield Investing, my team and I have a plan to profit from this. In the meantime, we have a solid portfolio full of market-beating yields that reward investors year after year. Go here to learn more now.