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Rekenthaler Report

Thoughts for Today's Bond Market

Preparing for rising interest rates.

Parsing the Data
Morningstar's Markets Research group has assembled a PowerPoint presentation entitled Investing in a Rising-Interest-Rate Environment. (The link goes to Morningstar's Institutional Library, as the presentation isn't yet available to the general public.) The material sets the current bond market in context--what it means to be invested when interest rates are relatively low, and may soon be rising.

Key points:

1) Interest Rates Remain Unusually Low
You probably knew that. Still, the reminder may be helpful. As the 30-year Treasury yield is now at 3.8%, up sharply from its rate of 2.8% only six months ago, bondholders may be pardoned for thinking that rates have moved up to near-normal levels. That is not so. Since 1926, long Treasury yields have averaged 5.2%.

Similarly, intermediate government bonds are well below the historic mean of 4.5%. Treasury bills, of course, currently pay nothing, which is also atypical.

2) Long Bonds Remain Dangerous
That's also something you probably know--although to judge from the squawking about bond-market losses, some do not. Whereas intermediate-length Treasuries almost never shed 10% in total return during a bond-market sell-off, long Treasuries have done so a dozen times. Three of those 12 declines have occurred over the past five years--highlighting just how easy it is to lose money quickly during a low-rate environment.

3) High-Quality Corporates Look Relatively Cheap

Source: Morningstar.

Intermediate-term corporate bonds now pay about 2 percentage points more in yield than do Treasuries. That spread is higher than the long-term average. (The yields look better yet when expressed as a ratio of corporate/governments, since the baseline is low.) With corporations boasting fat profits and healthy balance sheets, and recession not even remotely in sight, now would seem to be a good time to assume that extra credit risk. (Note: This argument doesn't apply to junk bonds, which are less attractively priced, in my view.)

As suggested by the arrows in the chart, the Markets Research team suspects that some of the yield gap owes to the artificial buying pressure induced by quantitative easing (QE) measures. As QE creates direct demand for government bonds, but not for corporates, it's possible that government-bond prices have benefited more from the Federal Reserve's purchases. If so, government bonds figure to perform worse when QE ends.

4) When Rates Rise, Stocks Figure to Beat Bonds--Barely

Source: Morningstar.

In general, stocks perform worse when interest rates rise than when they decline. However, even when rates rise, stocks often manage to tread water. Bonds, of course, are outright losers.

That makes sense twice over. Stocks fare worse when interest rates rise because higher rates mean a higher cost of money, which makes future stock dividends (or capital gains if the stock is sold) less attractive. The asset becomes less valuable. The process is reversed for declines in interest rates.

Why, then, are stocks on average flat when interest rates rise? Shouldn't they lose money as bonds do? The answer, it seems, is that the marketplace partially anticipates the increase in rates. Investors don't forecast the event entirely, because rates cannot be fully predicted. However, the marketplace does have a general sense of when interest rates might rise, and when that sense kicks in, it marks down stocks accordingly. Thus, when rates do rise, stocks absorb only part of the damage, because that part has already occurred.

At least I think that's what happens. Of course, as with general rules, there are plenty of exceptions--this year being one of them. If bond yields were to rise in the second half of 2013, then by this partial-anticipation theory stocks should have taken their lumps in the first half of the year. They did not. Nor did stocks feel pain in the second half. 

Good times. I certainly would not expect such stock-market fortune during the next interest-rate surge.

5) Bonds Still Appear Pricier Than Stocks
Since the Eisenhower years, Treasury yields have generally been much higher than the dividend payout of large-company U.S. stocks. Setting aside the extraordinary period from the middle 1970s through the early 1980s, when the yield gap between Treasuries and stock dividends rose to as high as 9 percentage points, the norm has been 2 to 3 percentage points. Today, that spread is 0.8 percentage points, as 10-year Treasuries are at 2.7% and the S&P 500 is paying 1.9%.

That's the largest gap since 2008, suggesting that stocks have become less attractive as they have appreciated. (Deep insight that.) It remains a small gap by 60-year standards, however.

Those who wish to view stocks as the more expensive of the two asset classes can take solace in the pre-Eisenhower data. From 1871 until the early 1950s, stocks almost always paid more than government bonds. By that standard, stocks today are dangerously overvalued relative to Treasuries. I'm not much convinced by that argument, because I think that if a pattern hasn't been observed in 60 years, it's probably because conditions have changed. Stock skeptics might have another view, though.  

In my portfolio, I hold cash rather than bonds. I don't wish to lock into yields at today's low rates. If I were in bonds, though, the presentation suggests that I: own intermediate-term issues rather than long bonds; favor high-quality corporates over Treasuries; and consider other assets, stocks included, as a hedge against further rate increases.   

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.