The bear market you should be worried about

From Greg Wilson, Analyst, the Palm Beach Letter:

Take a look at the table below. It shows the annual returns of the Bloomberg Barclays U.S. Aggregate Bond Index dating back to 1980:

The index covers roughly 8,200 fixed-income securities. And its total value is roughly $15 trillion. It’s basically the bond version of the S&P 500.

What do you notice in this table?

What I notice is that bonds have only had three losing years (1994, 1999, 2013). And on top of that, the index hasn’t had consecutive losing years since at least 1980.

That means anyone under 40 years old has never seen a bond bear market in their lifetime.

I bring this up because this year, bonds are now on pace to have their worst performance since 1976. And as I’ll show you in a moment, it may be just the beginning.

Income Exodus Is Underway

Income Exodus (or Income Extermination) is when bond investors get “exterminated” by rising interest rates. As interest rates rise, bond prices drop. So when interest rates rise rapidly (like they are now), bond prices drop a lot.

That’s important because there’s a good chance bonds will finish 2018 with their first losing year since 2013, and only the second losing year in the last 19 years.

The iShares 7-10 Year Treasury Bond ETF (IEF) is down 3.8% year-to-date. And the iShares 20+ Year Treasury Bond ETF (TLT) is down 9.7% year-to-date.

In the past, a down year in bonds has always been followed by an up year. But this time could be different.

Let’s take a long-term look at the U.S. 10-year Treasury rates to get a better big-picture view…

When the trend is rising, bond prices are falling (a bond bear market). And when the trend is declining, bond prices are rising (a bond bull market).

As you can see, rates spent the last 38 years declining—meaning, bond prices were going up. It was a long bond bull market… But now, the trend has been broken. And the data says the bond bear market is just starting.

Three Reasons the Bond Rout Can Continue

I see three more reasons why you should be cautious of bonds going forward: rising interest rates, rising inflation, and rising debt.

Rising interest rates

The Federal Reserve has hiked interest rates eight times since December 2015. And while Fed chair Jerome Powell recently said the Fed is close to getting rates to neutral, it’s up for debate on what exactly that means. The point is, it’s likely we’ll see more rate hikes in 2019.

The federal funds rate influences interest rates across the economy. As the rate rises, so does the cost of doing business. To compensate for the increased costs, bond investors will want higher yields. And that means lower prices for bonds.

Rising inflation

The costs of goods and services are rising. As prices rise over time, purchasing power decreases. To compensate for the loss of purchasing power, bond investors will demand higher yields—which, of course, means lower bond prices.

Rising national debt

U.S. debt stands at a record $21.2 trillion. The total public debt as a percentage of GDP is 104%. That means for every $1 of GDP, there’s $1.04 in public debt. That’s its highest level since 1966.

The recommended debt-to-income ratio is 35% or less. So most of U.S. revenues will go to debt servicing, leaving little for everything else. That’s risky. Bond investors will demand higher yields to compensate for this risk. That means lower bond prices as well.

With a bond bear market headed our way, what’s an investor to do?

How to Avoid the Bond Rout

For those who want to protect themselves from the Income Exodus, consider buying short-term government bonds. These are bonds that mature in two years or less.

Their par values won’t decline much as interest rates rise. That’s because the closer a bond is to maturing, the less its price fluctuates due to changing rates.

Regards,

Greg

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