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Will Bonds Be ?Burnt to a Crisp??

October 16, 2012

by David Schawel, CFA

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.  This article originally appeared on the CFA Institute’s Inside Investing blog.

Bill Gross’s recent monthly commentary painted a disturbing picture for investors – he foresees bonds being “burnt to a crisp.”  This isn’t just hot air. Such a conflagration is possible, and investors in bond funds, especially those that are constructed similar to the widely followed Barclays bond index, need to heed risks inherent in today’s market.

Understanding the capital flows caused by the Fed’s balance sheet expansion is important – for a refresher, see my earlier post on quantitative easing, which went through the mechanics of QE3 and how it has affected various fixed-income classes,  But the fine points of QE3 are not essential to understanding the full fixed-income universe.

In fact, the lion’s share of the fixed-income universe is not in the segments I discussed in that earlier post but, instead, in U.S. Treasuries and agency mortgage-backed securities (MBS). The common fixed-income benchmark for these is the Barclays Capital Aggregate Bond Index (AGG).

The longer view

Before we delve into the immediate situation in the bond markets, it’s worth considering the bigger picture: If the government does not get its fiscal house in order, the Fed will be stuck printing money to cover its debts. Gross was right in highlighting this problem, and it’s certainly a concern.

Gross, however, went a step farther and asserted that the United States will resemble Greece if it doesn’t conquer its deficits. That is nonsense. The United States is a currency issuer and can never run out of dollars. Greece, in contrast, is a currency user and cannot issue euros.

Investors are coming to the conclusion that our economic problems cannot be solved by monetary policy alone. Fiscal policy will be the key determinant of future economic performance. In the short term, however, Fed policy will be the main driver of fixed-income asset prices.

What’s my upside?

As with any investment, it’s especially important, given current uncertainty in the bond market, to understand the inherent risk-reward characteristics of a bond.

Consider a Treasury bond maturing August 15, 2022 (10-year proxy), with a coupon of 1 5/8 trading at par, thus a yield of 1.625%. Now let’s pretend investors wake up to another round of fears in the Eurozone. Treasury yields plummet, and the 10-year yield falls all the way to 1.25%, which would be a record low.

The price at that point would rise to about 103.50, or a gain of about 3.5%. That’s relatively little upside, especially considering the unprecedented lows such yields would represent.

Conversely, if 10-year yields were to rise to 2.50%, the bond would drop to a price of 92.3, or a loss of nearly 8% -- more significant.

The objective of this simple exercise is not to say whether a 10-year U.S. Treasury bond is an attractive investment but, instead, to illustrate a basic fact – current low yields are limiting the upside of further gains in U.S. Treasury bonds.