Pushing on a string

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In an equity-centric world it sometimes easy to forget the unforgiving mathematics of bond pricing.  Unlike equities, fixed income securities have limits on their potential for capital appreciation.  Bond prices can only escape the inevitability of par for so long, absent a trip to bankruptcy court.  As the yield curve continues its path downwards the attempt to squeeze excess returns from the bond market becomes more like pushing on a string.

One can see from the chart below the downward moves in both the Treasury and BBB-corporate bond curves.  The moves are especially pronounced at the short end of the curve.

Source:  research puzzle pix

In today's financial markets it seems that we are beginning to see some of these limits come into play.  For example IBM was recently able to issue 3 year bonds at 1%.  Even an instantaneous drop in the yield by 50 bp yields only a 1.5% rise in the price of the bond.  In short, absent earning the coupon there is little in the way of capital appreciation opportunity here.

The aforementioned is an extreme example due to both its coupon and maturity, but it is indicative of the situation facing the overall bond market. Given the puny yields on so-called safe investments like bank deposits and Treasury securities it should not be surprising that individuals are in a desperate search for yield.  Cash has been flowing out of money market mutual funds in search of higher yields.

Given the recent performance of high yield bonds this is not surprisingly a likely destination for some of this cash.  Investors have been pouring money into high yield bond funds as defaults ebb.  From a Bloomberg article one fund manager called the market behavior "a little big bubblelicious."  The risk is that individuals don't know exactly what they are getting themselves into.  As Carl Richards wrote a few months ago:

One of the things that I'm most worried about right now is people taking money that they want to keep safe and trying to find investments that earn a yield that's a little higher. This is called "stretching for yield," and it can be be a dangerous game, especially if you don't understand the rules.

The logical conclusion is to short the bond market, right?  Some analysts like Doug Kass are currently recommending that approach.  Kass argues for getting long the ProShares UltraShort 20+ Year Treasury ETF (TBT).  While this approach is technically easy, one should recognize that this approach comes with some costs.  Those include the feeds of the underlying ETF and the costs of carrying the short bond positions themselves.

The other bigger picture issue to deal with is the case of Japan.  Japan has been mired for nearly the past two decades in a low-growth environment.  This has lead to 10-year JGBs now trading with a yield below 1.0%.  If one is an ardent believer in the deflation case, then current government bond yields may not seem all that high in the future.

In any event we should all get used to the notion that we are investing in a low nominal return environment.   Some interesting charts at EconomPic Data highlight the limits we are now facing in the bond market.  We should view future returns through the lens of current yields:

This equity-like performance of high quality bonds can not continue. At some point the level of yield… wins. With the current yield to worst of the "Barclays Agg" index at less than 2.6%, investors expecting anything more than 2.6% over the next 4-5 years (i.e. the duration of the index) will be disappointed.

There a number of implications from this discussion.  Included in this would be pension funds having to revisit their rate-of-return assumptions.  Playing a reversal in this interest rate trend remains an option, but it is not a risk-free one.  The bottom line is that fixed income investors need to face up to the realities of current bond prices and brace for an extended period of diminished returns.