Bonds are widely touted as “safe investments”. They are not.
Historically, stocks were seen as ‘risky’ and bonds as ‘safe’. This is because, if held to maturity, the bond is expected to pay out the entire principle. So even if your bond drops in price in the middle of the term, that price is to be paid in the end.
Especially in the aftermath of the latest stock market crash, folks have run in droves to the “Safety” of bond.
But bonds, especially as sold today, ‘have issues’. The first, and most obvious, is that in times of inflation that bond may pay you back full face value in 20 years, but only buy 1/2 the actual value. Holding long term bonds during times of inflation is a lethal combination, financially speaking. The second is the risk of default. How much do you think an Enron bond is worth right now?
So you have to keep in mind the default risk, and the risk of inflation. OK, any more?
Historically, the bond holders get ‘first claim’ on assets of a distressed company, ahead of stock holders. When GM hit the rocks, the U.S. Government stepped in and screwed the bond holders. Obama’s administration decided to give a great big wet kiss to the Autoworkers Union (who’s contracts would be abrogated in bankruptcy) and instead gave them 1/4 or so of the company. Taking another chunk for the U.S. Treasury. “Soon” there is supposed to be a stock sale back to the public (called an “IPO” for Initial Public Offering… but I must wonder how ‘initial’ it is for a company this old). All the prior stock holders got the boot out the door with nothing to speak of; while the bond holders who ought to have gotten ownership of the company got nothing. They get to continue to take all the risk, uncompensated for it, while ownership passes to “The Friends Of Obama” club. Very “not good” to bond holder rights.
For any given bond, the national central bank for the currency in question can ‘monetize debt’ and cause inflation. The Federal Reserve also sets the interest rates. Between these two, they control the eventual value of the principal to be paid out AND the present market price for the bond. When rates drop, bond prices rise (If a $1000 bond is paying 4%, why pay $1000 for a new 2% bond? The old one will instead sell at a premium. Conversely, why pay $1000 for a 2% bond if rates on new bonds are now %4? So you will only buy it at a discount. And that ‘premium’ paid over face value will not be paid to you as principal at maturity, it is ‘in’ the interest rate valuation at the time of sale / resale.)
The Fed presently has interest rates at 0% to 1/4% (basic Fed Fund Rate to other banks). It’s hard to go lower than zero. So bond prices have jumped up. WHEN (and it is a “when”) The Fed starts to raise rates, those market prices for bonds will begin to drop. And it can be fast and hard.
This is a graph of a 20 year bond fund. Notice that we have had a dramatic rocket ride up in bond prices lately as the Fed has cut rates. Then, at the end, a downturn as some good economic news made folks think maybe the 0% Fed Funds rate days are numbered.
The top chart is ‘static’ at a moment in time. The second chart is live, so you can see what’s happening now. You can click on these to get much larger and easier to read version.
The “Live” version:
Notice how the price rises in an accelerating nearly parabolic way? That is usually followed by a rapid fall, that we see happening / starting at the right side. We also note that the bottom indicator, DMI, has “Red On Top” now, that the middle indicator MACD has a ‘crossover to the downside” with the opening between the red and blue lines pointed downward. Also of note, Slow Stochastic said this trade was ending a little while back…
So for ‘some time to come’ the trade is to be out of bonds. How long? That will depend entirely on The Fed. They could buy $500,000 Billion of bonds tomorrow and spike the price back up, or they could raise rates to 1/4%-1/2% and drive them down. But the best bet is likely a bit of both activities, with time to gracefully exit bond holdings. It will take a year or so for the economy to get rolling really well, and not much is likely to be done until after the November elections. But I’d start easing for the exit now.
But Wait, There’s More!
Few individuals these days buy a lot of individual bonds. They buy a bond fund. For diversification. For built in ‘management’ as the bond fund does all the buying and selling. But this has a major major impact:
A bond FUND never matures
So when The Fed starts raising rates, you can not simply choose to ‘hold’ and eventually get paid your principal in full as a holder of an actual bond could do. Some of the folks in the fund will cash out and that quantity of bonds will be sold right then at market rates, never maturing in the fund. Any losses are locked in.
So holders of bond FUNDS really just have a bet on the direction of interest rates and the security of the lender.
And we know interest rates are not going below zero any time soon.
My conclusion is that it’s time to start easing out of bond funds before The Fed does the first rate hike. The present prices are nearing the SMA stack from the top side (so the best time to sell was some days back) and there is the chance they may make one more spike up before this is all over. (Markets often end with a ‘double top’ where prices try to regain past glory and fail to advance). It is unlikely to be a full fledged “rout” until The Fed actually does start raising rates. But it’s also pretty clear that the bulk of the party is over and the bulk of the risk is still in front of you.
Manage the Risk and the Reward will take care of itself. -E.M.Smith
And that means leaving this profitable trade while the reward is still in hand and while the risk can still be left for others.
Can’t stand the idea of CDs or stocks at the moment?
OK, you can always just “shorten the maturity”. Roll out of those 40 year, 30 year, even 20 and 10 year maturity bonds and bond funds and into 1 year or even 90 day paper. You still have the ‘full faith and credit’ of the issuer, but have much less interest rate risk. Short duration bonds do not respond much to rate changes.
And yes, this applies to “TIPS” too. (Treasury Inflation Protected Securities). The yield on them is down at a fraction of a percent anyway and you can do much better in good utilities or oil and gas trusts. But the chart tells the same tale. Time to exit.
RSI is having approached 80 hitting lower highs. DMI is “red on top” and MACD is “opening downward” after a crossover to the downside. Time to be gone.
For hard core traders, “Time to be Gone” also can mean “Time to be Short”. This chart is the TBT, a vehicle that shorts long term bonds, but trades like any other stock ticker. So you could ‘flip’ your position from TLT to TBT and work both the up and down trends. Notice that the indicators here say to be in, with the crossovers happening to the upside after a long downward run.
RSI approached 20, then heads up. MACD doing a ‘crossover to the topside” and DMI is just about ready to be “Blue on top”. As long as MACD is below the zero line and while price is below the SMA stack, we have an ‘unconfirmed’ buy trade. I would expect price to cross the SMA stack to the topside (and perhaps then dip back down to touch from the top) while DMI goes clearly “blue on top” and MACD heads to over the zero line. Those all confirm the trade and tell you to stay in it longer. If those don’t happen, it’s just a dead cat bounce into a flat trendless vehicle. You can ride the bounce, but exit when Slow Stochastic or MACD turn against you…