Just When Everyone Loves Bonds, I Don’t

In retrospect the toughest investment picks almost always seem to have been easy. “Of course” everyone knew that the dot-com bust would occur; a few years later, wasn’t it crystal-clear that housing was almost as ridiculous a bubble, doomed to burst? Actually if you read the stories of the time, few were focusing on these soon-to-be-front-page events.

I believe it is similar in bonds today. Just when money is piling into bonds to the exclusion of everything else, when the only bond market sector that is even slightly down in 2010 is the equity-like high yield domestic bond market, when even low-yielding mortgage-backed securities (MBS) continue to implausibly rally, that’s when I predict bonds will have very low returns going forward from this time, for at least a year.

You know you’re in trouble when you have to invest in a five-year Treasury note yielding a paltry 2.03%! No matter what you say about the depressed nature of inflation and its unlikely near-term recovery, there’s still a lot of risk that something bad might happen to your investment in two or three years. That’s even truer of the ten-year Treasury at only 3.25%. The only thing you can say for the ten-year is that it’s yielding quite a lot more than the 5-year – completely trite, I know, but that’s it – no need to over-analyze!

In addition to simple mean reversion of performance, there is more to it. Fundamentals have gotten way out of whack. Merrill Lynch’s calculation of the option-adjusted spread over Treasuries for MBS is an eye-popping minus 13 basis points! Can this negative spread go even more negative? Anything’s possible over the short run, but this amazing run of already-low-yielding negatively convex securities has to end, probably when investors start to realize how low their expected return really is, and get tempted when other asset classes begin to look like bargains.

The long end of the yield curve has also rallied dramatically. I loved Build America bonds last year, but this year the index of these bonds has soared 6.8 points! Granted, most of that has merely been to keep up with soaring Treasuries, which I really hate. But the BABS spread has come in, albeit modestly, from 187 bps to 181 bps, and this now looks unfavorable compared to much-shorter, and therefore less-risky, corporate bonds, which have a better yield spread (213 bps) for only a medium amount of duration risk.

In summary, there is little to recommend in bonds today except some intermediate corporate bonds, which should do relatively OK, but not spectacularly (as they did from 3/09 to today). The arcane world of distressed residential mortgage-backed securities (RMBS) may also post decent returns. The much-maligned equity market will probably rally to take up the slack left by the poor-performing bond market, once the fear subsides of an EU-inspired (and US. lingering high unemployment-inspired) new leg of the world recession.

And one thing is for certain, when U.S. Treasury and mortgage-backed securities are yielding 100-200 bps higher in yield in a year or two, “everyone knew” it was coming!

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