Monday, April 2, 2012

Knowledge@Wharton: "The End of the 30-year Bond Bull Market?"

From Knowledge@Wharton:
Is the great 30-year bull market in bonds coming to an end? Yes, perhaps -- or maybe not: It depends on whom you ask and how flexible your timing is.

While many people think of bonds as conservative holdings, they have produced stellar returns for decades, thanks to the taming of inflation and other factors. A basket of stocks would have returned a mere 19% from the start of 2000 through 2011, for example, while a basket of bonds would have returned about 113% through a combination of rising prices and interest earnings.

But many experts say economic recovery could now reverse the process by driving interest rates higher, causing bond prices to fall. Yield on the 10-year U.S. Treasury rose to around 2.25% in March, after hovering around 2% for four months. "I think bonds are less attractive than they have been for a long time," says Scott Richard, Wharton practice professor of finance.

But rising rates and falling prices are not necessarily coming so soon, according to Wharton finance professor Franklin Allen, who notes that short-term rates in Japan have stayed extraordinarily low for many years. Though the odds favor a rise in rates, strong demand for high-quality bonds, particularly U.S. Treasuries, could persist for some time, he says, keeping prices high and yields low. "I think [Treasuries] are still very much a safe haven, and that's why interest rates are so low, even though there are many things to worry about." He adds that there is a chance they will stay low "for a very long time."

However, according to Wharton finance professor Krista Schwarz, "It's virtually impossible to forecast future yields. One can talk about risks to the upside and risks to the downside, but both risks always exist."

From Bull to Bear
Clearly, the U.S. economy is gaining steam, though slowly. Typically, that causes interest rates to rise, which drives bond prices down -- turning a bull market into a bear. But the economy has had false starts in the past. Signs were good early in 2011, but progress stalled amid the European debt crisis and the tsunami and earthquake in Japan. Most experts agree that economic signs are even stronger this year, but many warn that progress could be derailed by government debt problems in the U.S. and Europe, rising oil prices and ripple effects from a slowdown in China and other emerging markets. In the U.S., the troubled housing market continues to dampen recovery.

Uncertainty drives investors to pursue safety, which pushes businesses, individuals and foreign governments to stock up on U.S. Treasury securities, the modern world's safe haven. The Treasury market is big enough to soak up worldwide demand, and safe because it is backed by the government's power to tax. High demand has driven bond prices up and forced yields to extraordinary lows.

Still, bond market experts point to a simple, undisputed fact: Yields on Treasuries and other highly rated bonds are so low they cannot go much lower. Historically, they have been much higher, and the law of averages says they should rise again. Currently, the 10-year U.S. Treasury note yields a meager 2.25%, down from around 5.25% before the financial crisis struck in 2008. It has not been lower since the 1940s, and has spent most of the past seven decades in the 4% to 8% range, peaking at more than 14% in the early 1980s....MUCH MORE