Bond Market Crash

Corporate bonds crashed the last two weeks. Here is the chart of the high quality stuff – The Investment Grade Corporate Bond Fund (LQD). This is the little old lady portfolio where you are supposed to be able to hide your money when all you want is income and little price volatility.
This index has fallen 24 percent this year. 24 PERCENT!!
Grandma is going to get her statement at then end of the month and keel over...

Compare the performance of Corporate Bond to the performance of short-term US Treasury Bills (SHY), which are at their highs for the year!

I have been hiding is short-term Treasuries and CDs for over a year. Sure, the yields have stunk. But I have been more concerned about return of my money, rather than return on my money. I appreciate the patients of clients during the last 12 months of low yields, but the hand writing was on the wall for this disaster since at least 2006.

I want to look at a couple of popular strategies for capturing higher yields. These strategies are Bull Market strategies that use leverage to build portfolios of bonds that benefit from rising short-term interest rates. The biggest of these is the
Van Kampen Senior Income Fund (VVR), with $2.3 billion in assets. VVR was only down --10.45%. TODAY!!

The PIMCO Corporate Opportunity Fund (PTY) also uses leverage to buy lower-quality bonds in order to get enormous yields. It only fell -9.02% this week, but is down -30.9% from its high for the year. I am now looking out my window a couple times a day to make sure that nobody from PIMCO has jumped from the building...

Again, these are Bull Market strategies that borrow money to buy Junk Bonds (now called “High Yield”) to try and generate big yields. High yield bonds get crushed during recessions as their default rates go from an average of 1% to 6% in a two year period. During recessions, Junk Bonds end up yielding 10% more than US Treasuries as investors sell them and their prices crater.

Even the bonds of other governments are not immune to the carnage in bond land this year. The debt issued by Emerging Market countries has fallen hard, as the Alliance World Dollar Government Fund II (AWF) illustrates.

If you think I am cherry picking bad charts to prove a point, then go to http://www.cefa.com/ and you will see that these charts are indicative of the performance of these asset classes.

My big concern is that bond prices are not just falling because of deteriorating economic fundaments and massive unwinding of leverage. My fear is that long term bonds are finally starting to price in the reality that interest rates are going to go through the roof as the government prints trillions of new dollars, resulting in massive inflation.

I know the numbers for inflation are relatively low in the US, but I think the numbers for our CPI are fake (a topic for future discussion). Here is a chart of the combined CPI for nine major industrialized countries. As you can see, their rate of inflation is twice what ours is. So either they are not buying the same stuff as us (exotic stuff like food and gas), or our numbers are artificially low compared to reality.

I am afraid that the pain in Bonds is just starting. Heed my warning, do not go out an buy a portfolio of long-term bonds because the yields are attractive relative to money market rates.

Yields on the 30-year US Treasury are at historic lows, and do not have far to go until they reach zero. They have been kept low by design to stimulate consumption. At some point they will need to be brought to extremely high levels to crush the inflation wave which is inevitable. That is where bond prices will get crushed and you will lose a lot of money if you hold a portfolio of long term bonds.

Here is the yield on the 30-year US Treasury Bond ($TYX = 30-year yield x 10).

Here is the price of the 30-year US Treasury Bond ($USB). Prices are approaching an unbreakable ceiling as rates approach zero.

To summarize, Corporate Bonds have been annihilated this year, while US Treasury Bonds and Bills have continued to new highs as people buy them up in a flight to quality.

There will be a time in the next 12 months where the Bond Markets begin to price in economic growth and the trend will reverse. At that point, I will be looking to buy Corporate Bonds and sell short-term US Treasury holdings. Moreover, I will be looking to abandon Long Term Bonds and buy inflation-adjusted short and intermediate term bonds to protect myself from the ravages of what seems to be certain, significant future inflation.