Daily Gains Letter

Bond Market Headed for a Collapse?

By for Daily Gains Letter |

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Investors beware: the bond market is treading in dangerous waters. The risks are increasing, and if all the pieces of the puzzle fall into place, it can make a significant dent in your portfolio.

Look at the chart below of yields on long-term U.S. bonds. It shows the yields continuing to increase, while bond prices are falling.

Since the beginning of May, the bond market has seen a massive sell-off. Going by the chart above, yields on the 30-year U.S. bonds have increased more than 30%. This is significant and shouldn’t go unnoticed, because long-term U.S. bonds are used as a benchmark for rates on other bonds in the bond market. If the U.S. bonds decline in value, their yields increase, and the bond market usually moves in the same direction.

We are seeing that investors have started to flee the bond market already.

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According to the data from Investment Company Institute, in June, the U.S. long-term bond mutual funds witnessed their first outflow since August 2011, with outflows amounting to more than $60.4 billion. In May, there were inflows of $12.2 billion. (Source: “Historical Flow Data,” Investment Company Institute web site, last accessed August 8, 2013.)

Why is this happening? The Federal Reserve, which has kept the bond yields lower by becoming a major purchaser of U.S. bonds, is contemplating when it should decrease the amount of its monthly bond purchases. There is fear that a cut in the Fed’s bond buying could further escalate the sell-off in the bond market.

On top of this, there’s a notion that the U.S. economy is getting better. Investors usually run towards the bond market during times of stress, and with the sell-off currently out of the picture, more pressure has been added.

What should an investor do?

The bond market certainly remains in dangerous territory, but it is very difficult, if not impossible, to tell how much the yields will rise and where the bond prices will go. As it stands, there is much noise around the prices; some are calling for an outright collapse in the bond market, while others want a modest increase in the yields.

Investors need to be careful before investing into bonds and bond funds by performing a critical test: checking their duration.

At the very core, duration shows how sensitive a bond is to the change in interest rates. One rule of thumb investors should remember is that the higher the duration, the bigger the impact will be on the bonds.

Although calculating duration can be difficult on its own, the majority of the bond funds and exchange-traded funds (ETFs) investors may invest in provide this number. Consider the PIMCO Total Return Exchange Traded Fund (NYSEArca/BOND); according to the company, its duration is 5.26 years. (Source: “PIMCO Total Return Exchange-Traded Fund,” PIMCO web site, last accessed August 8, 2013.) This simply means that for every one-percent increase in the interest rates, this ETF can lose up to 5.23% of the portfolio value.

With all this said, investors need to keep in mind that since the financial crisis, the interest rates in the U.S. economy have been very low—they must ask themselves if the rates can go any lower. With the entire stimulus and quantitative easing combined with easy monetary policies; interest rates have a greater risk of ticking higher—and could, therefore, spur further selling in the bond market.

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