Financial Fundamentals

Bloodletting in the Bond Markets: The ‘New Abnormal’?

by Thomas K. Brueckner, Strategic Asset Conservation

The last six weeks on Wall Street have even veteran market watchers perplexed. At this writing, seven of the last 12 trading days have seen triple-digit inter-day swings in the Dow Jones Industrial Average, and losses of over 5 percent. Thirty-year mortgage rates are up 0.6 percent in seven weeks, as the yield on the 10-year treasury has reached as high as 2.23 percent before retreating slightly—with every bond fund category at Morningstar posting a negative return for the month. This prompted Richard Ketcham, chief executive at FINRA, the Financial Industry Regulatory Authority, to state, “There’s a lot more room for rates to go up than down. [Bond] losses of 5 percent to 10 percent are perfectly reasonable to expect,” and bonds “may be safer than many investments, but they’re not riskless.” Simply put, as the economy improves and stocks become the preferable alternative, investors are getting out of bonds, all sorts of bonds, but primarily U.S. treasuries. The yield on the 10-year treasury is climbing, despite the Fed’s longstanding efforts to keep it low; as investors sell, the price drops while the yields climb, given the inverse relationship between them. Rates on the 10-year had fallen to as low as 1.38 percent last year. Fed Chairman Bernanke also spooked the bond market with talk of “tapering” the purchase of $85 billion per month of mortgage-backed securities, the once-toxic instruments that had done so much damage to the housing market in 2007-2008. Investors are concerned that as the Fed chairman provides less support for investors, he may be creating an incentive for them to pocket their gains to date and sit out the rest of the year. The resulting sell-off could become endemic—as it was in 2000-2002 and again in 2007-2009—a third self-fulfilling swing of the pendulum. In a strikingly candid post last week, the usually stoic Guggenheim Partners’ CIO Scott Minerd wrote that “the only reason investors would buy treasuries today is they expect the Federal Reserve will buy them at higher prices in the future. This reasoning will come unstuck, however, once the Fed curtails its asset purchase program. We do not know when the Fed will taper QE, but the longer its expansionary policy continues, the more volatility-inducing pressure will build. That means stock and bond markets appear to be in for a rough ride over the next six months or so. Minerd then called the current situation “a Ponzi market in treasuries,” garnering him the lead headline on MarketWatch.com that afternoon. Risk for Retirees What does all this mean for retirees and those approaching retirement? Think about the standard portfolio of 60 percent equities and 40 percent bonds typically recommended to a 40-something investor. As he ages, that client’s stock/bond balance changes (or should), with most advisors recommending less equity risk and more bond “safety” since bonds are deemed to have less principal risk than stocks. A 72-year-old, for example, may have a stock-to-bond ratio of 30/70, believing that the 70 percent he has in bonds is safe and protected. To wit: When the head of FINRA is quoted as saying that bond losses of 5 percent to 10 percent are “perfectly reasonable to expect,” reminding retirees that bonds “are not riskless,” those retirees should ask themselves a fundamental question: How much of the money that it’s taken us 40 years to save can we comfortably afford to lose without having it adversely impact our plans for a sustainable retirement? The bloodletting in the bond market will continue. Emerging market sovereign bond funds (dollar-denominated debt) just posted their biggest outflow since early 2007. Even emerging market corporate bonds are selling off for the first time since early last November, not a good sign for the once-sexy private sector alternatives to once-stable government debt. The real risk in all of this is that retirees may be tempted—perhaps by their advisor—to replace too much of their bond allocation with equities, the very thing prudence dictates not to do at that age, with a premise that risk may be safer than safety. Adds famed economist Nouriel Roubini: “Be sure your seat belt is fastened, because nothing has really come to rest. We have entered the New Abnormal, a period in which every market assumption must be questioned and the wise investor is prepared to be surprised.”

Thomas K. Brueckner, CLTC, is president/CEO of Strategic Asset Conservation in North Scottsdale, a conservative wealth management firm with clients in 18 states and six countries. He is a 2011 Advisor of the Year national finalist, a radio talk show host, and a mentor to other advisors nationally. He may be reached for comment at go2knight.com.