Excellent paper about bonds and the 30-year Bond Bull Market

[MekongTrader]

Hello Bogleheads,

This is an excellent paper from Wharton School of the University of Pennsylvania.

http://knowledge.wharton.upenn.edu/arti ... cleid=2965

It explains bonds and the 30-year bond bull market. How this bull market came about, implications for bond holders if rates do rise and in particular how bond mutual fund holders will be affected.

Written in plain English, very easy to understand.

Merry Christmas to everybody

MT

[richard]

"But rising rates and falling prices are not necessarily coming so soon, according to Wharton finance professor Franklin Allen, who notes that short-term rates in Japan have stayed extraordinarily low for many years."

Japan's recently elected prime minister campaigned on a platform that includes increased government spending and Japan's central bank targeting higher inflation, which should result in rising rates. In fact it has, as well as a rising stock market.

"Uncertainty drives investors to pursue safety, which pushes businesses, individuals and foreign governments to stock up on U.S. Treasury securities, the modern world's safe haven. The Treasury market is big enough to soak up worldwide demand, and safe because it is backed by the government's power to tax. High demand has driven bond prices up and forced yields to extraordinary lows."

Uncertainty and lack of attractive alternatives have pushed investments in treasuries, as well as the government bonds of every major country which issues debt in a currency it controls. High demand and low supply has pushed up prices. If supply increased to meet demand, prices would not have risen the way they have. BTW, when do we ever not have uncertainty?

"Rising rates would also be hard on U.S. taxpayers, who would have to pay more to finance the government's $15 trillion debt."

We're not likely to see rising rates until the economy recovers. At that point there will have higher incomes, resulting in higher after tax incomes.

"But long-term rates are in part a bet on what short-term rates will be in the future, so the Fed's downward pressure on short-term rates puts downward pressure on long-term ones as well."

The idea of low rates is to increase economic activity. Higher economic activity raises rates. If the Fed succeeds in helping to grow the economy, long rates will rise.

"But bond investors could be hit hard, analysts note, as higher yields on new bonds would drive down values of older, stingier bonds already in investors' portfolios. The great bull market could turn into a great bear market."

If you are reinvesting cash flow (dividends and principle), higher yields result in higher returns over time, despite the short term pain of lower asset values. Those who are investing for the long-term are helped by higher rates, not hit hard.

[Clive]

"But rising rates and falling prices are not necessarily coming so soon, according to Wharton finance professor Franklin Allen, who notes that short-term rates in Japan have stayed extraordinarily low for many years."

But Japan has seen a (generally) appreciating Yen in compensation

We're not likely to see rising rates until the economy recovers

Or the global outlook is less bleak. Investors will accept negative real yields for a while, but as soon as there are reasonably safe alternatives elsewhere, money will flow towards those positive real yields and treasury yields may have to rise in competition. Longer term historic averages are for (broadly) 2.5% to 5.5% yields on longer dated treasury's (30 year). A rise from recent 2.9% 30 year levels to 5.5% 30 year = -38% capital decline.

If yields rose to anything like the 1980's levels



capital declines could be -80%. i.e. LTT's are more stock like risk with less than stock upside potential reward at current levels. Given a decade+ of relatively flat (over total period) stock gains, there are many who currently prefer stock/cash (STT) to that of longer dated treasury's.

[richard]

"But rising rates and falling prices are not necessarily coming so soon, according to Wharton finance professor Franklin Allen, who notes that short-term rates in Japan have stayed extraordinarily low for many years."

But Japan has seen a (generally) appreciating Yen in compensation

The yen has been dropping since Abe's election, while Japan's equity markets have been rising.

Japan usually exports more than it imports, so a high yen hurts more than it helps. This hasn't been true very recently, so a lower yen should restore tradition.

We're not likely to see rising rates until the economy recovers

Or the global outlook is less bleak.

Fair enough. The market tries to be forward looking.

[Clive]

Treasury yields might remain low as long as the incestuous buying (by the Fed Reserve) of new bonds continues. Other countries simply print enough new money of their own to buy additional US T's in order to maintain the overall value of their existing holdings (prior 5% return on $10B of holdings -> 2.5% return on $20B of holdings ($10B additional new money printed in their own respective country to buy those extra bonds)). Hence gold has risen more or less evenly across multiple currencies as others print new money in synchronisation.

A risk is that as those bonds mature, the others might be more tempted to roll the proceeds elsewhere and US T yields might have to rise to attract inward investment (quantitative tightening). There are signs that China is only printing/buying enough US T's to maintain their existing holdings value and the remainder of their surplus is being directed anywhere else other than US T's. At some point it might be more appealing to dump their US T holdings perhaps in anticipation of rising yields (lower prices/capital losses) which could induce a 1980's type rise in yields.

Weren't the Rockefeller's heavily into oil in the 1970's? I heard the other week that as the Chinese prosper and more start owning their own car, that they could end up requiring the entire global oil supply in order to fuel those vehicles!

[NYBoglehead]

^ If I were a betting man I'd say natural gas operated vehicles will become more prominent over the next decade. So I'm not worried about Chinese drivers taking up the global oil supply. I am concerned about the incredibly low interest rates on bonds and the long-term effects of an extended period of low rates as my parents enter their retirement years. A lot of talk on this board has been about Japan and how we do not know when rates will rise. That is true, but what we do know is that there really isn't much further they can fall and the TOTAL RETURN for bond funds in the near-term appears to be nothing more than the interest it will provide (ie very little room for price appreciation with the rates already so low).

[Call_Me_Op]

The article says a 30 year bond can lose 10% of its value for a 1% rise in prevailing rates. Aren't they understating the loss in this environment?

[Don Christy]

From the article, written in March, 2012 (emphasis added):

Still, bond market experts point to a simple, undisputed fact: Yields on Treasuries and other highly rated bonds are so low they cannot go much lower. Historically, they have been much higher, and the law of averages says they should rise again. Currently, the 10-year U.S. Treasury note yields a meager 2.25%, down from around 5.25% before the financial crisis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peaking at more than 14% in the early 1980s.

Actually, currently, the 10-year U.S. Treasury note yields an even more meager 1.75% and has been as low as 1.4ish% after the article. So much for undisputed facts.

[grayfox]

From the article, written in March, 2012 (emphasis added):

Still, bond market experts point to a simple, undisputed fact: Yields on Treasuries and other highly rated bonds are so low they cannot go much lower. Historically, they have been much higher, and the law of averages says they should rise again. Currently, the 10-year U.S. Treasury note yields a meager 2.25%, down from around 5.25% before the financial crisis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peaking at more than 14% in the early 1980s.

Actually, currently, the 10-year U.S. Treasury note yields an even more meager 1.75% and has been as low as 1.4ish% after the article. So much for undisputed facts.

If I had a nickel for every time some expert said that something could not happen, and then it happened, well, I'd have a few nickels.

[rkhusky]

From the article, written in March, 2012 (emphasis added):

Still, bond market experts point to a simple, undisputed fact: Yields on Treasuries and other highly rated bonds are so low they cannot go much lower. Historically, they have been much higher, and the law of averages says they should rise again. Currently, the 10-year U.S. Treasury note yields a meager 2.25%, down from around 5.25% before the financial crisis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peaking at more than 14% in the early 1980s.

Actually, currently, the 10-year U.S. Treasury note yields an even more meager 1.75% and has been as low as 1.4ish% after the article. So much for undisputed facts.

I suppose it depends on how you define "much lower".

[Don Christy]

From the article, written in March, 2012 (emphasis added):

Still, bond market experts point to a simple, undisputed fact: Yields on Treasuries and other highly rated bonds are so low they cannot go much lower. Historically, they have been much higher, and the law of averages says they should rise again. Currently, the 10-year U.S. Treasury note yields a meager 2.25%, down from around 5.25% before the financial crisis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peaking at more than 14% in the early 1980s.

Actually, currently, the 10-year U.S. Treasury note yields an even more meager 1.75% and has been as low as 1.4ish% after the article. So much for undisputed facts.

I suppose it depends on how you define "much lower".

My point is just that (if I'm doing my math correctly) since the "experts" stated that "indisputable fact," the price of the 10 year Treas is up 6%. Experts were saying the same thing about yields a year ago, and two years ago. Sure they'll go up at some point, but what's your alternative in a reasonable portfolio, CDs, I Bonds, payoff mortgage? Limits and issues with all of those too. And yields could go lower and may stay low for a long time... or not.