If You Own Fixed Income Funds, Watch for this Major Shift

The worst of the “fiscal cliff” impact may have been averted, at least for the moment. But now investors face a new concern: The debt ceiling drama.

The U.S. reached the current statutory debt limit of $16.4 trillion on December 31, 2012. And the Treasury Department has been employing creative financing measures ever since to finance about $200 billion in deficits in 2013.

This means Congress must act, again, as early as mid-February to prevent a U.S. debt default. Recall that a similar debt drama played out in the summer of 2011 leading to a downgrade of the U.S. credit rating. Now here we go again!

Washington essentially kicked the can down the road again with some tax increases, but no meaningful spending cuts. Instead, the $110 billion in automatic spending cuts have been delayed for a couple more months. In other words, this deal does little to address America’s chronic deficits.

As a result, we can surely expect more volatility in financial markets early this year as the debt ceiling drama plays out.

But …

The Bond Market Will Likely
Get Hurt More Than the Stock Market

With fiscal cliff uncertainty hanging over the markets in recent weeks, you might have expected U.S. Treasury bond prices to surge higher. That’s the typical flight-to-safety trade we’ve seen in the past, including the last debt ceiling drama in 2011. But the opposite happened this time around.

In fact, Treasury bonds have been falling steadily in price with interest rates rising in recent weeks. The iShares Barclays 20 Year Treasury Bond ETF (TLT), which tracks long-term government bonds, was one of the worst performing during the month of December, falling 2.9 percent. And it was down for full-year 2012 while the S&P 500 Index gained 13.5 percent.

The question for investors: Is this just a short-term reversal for Treasury bonds, or a lasting shift in trend.

Treasury bonds have been enjoying an unprecedented bull market since interest rates peaked in 1981. In the three decades since then, 10-year U.S. Treasury bond yields have declined from a high of 14 percent, to just 1.5 percent last year.

The corresponding gains for bond holders in recent years have been impressive. In fact, TLT has produced total returns of 11.2 percent over the past five years, and 7.8 percent over the past decade.

These equity-like returns are well above the norm for fixed income funds. And just like the unsustainably high returns for stock funds during the 1990s, they certainly can’t be counted on going forward.

The Risks Ahead …

After such a dramatic decline for interest rates, it’s clear the risks are on the upside with higher rates likely in the years ahead. In fact, it’s only a question of when — not if — yields will begin a sustained uptrend with bond prices falling.

And don’t think for a minute that it’s only Treasury bonds that are vulnerable.

Indeed, mutual fund and ETF flows follow returns. And performance-chasing investors have poured a lot of money into bond funds and ETFs of all types in recent years. High quality corporate bonds have performed particularly well with average returns of nearly 10 percent annually over the past three decades.

Money has poured into bond funds and ETFs as a result. In 1984 total fund holdings of corporate debt was just $16 billion. But today funds hold more than $1.8 trillion — about 18 percent of the value of the entire U.S. corporate bond market, according to Merrill Lynch research!

So the big risk is that bond fund and ETF investors could stampede to sell at the slightest hint of an uptrend in interest rates. Such bond fund outflows could easily feed into a vicious cycle of plunging bond prices pushing higher interest rates even higher and prompting more selling.

It’s important you realize that even a relatively small uptick in interest rates can have a large negative impact on price. Take TLT as an example.

In 2010, 10-year Treasury yields rose from a low of 2.5 percent in October to a high of 3.7 percent by February 2011. That’s a yield increase in interest rates of just 1.2 percent. But the price of TLT fell by 18 percent over the same period.

A bigger backup in interest rates happened in 2009, and TLT plunged over 26 percent in value. In fact, interest rate fluctuations of this kind are quite normal; typically they occur just about every year.

Soon we’ll experience another uptick in yields, you can count on that. But at some point, interest rates will just keep on rising, signaling a new secular bear market for bonds. So if you own fixed income funds and ETFs, you better stay alert for this major shift in market trend.

Good investing,

Mike