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July 28, 2014 at 08:01 PM
Heading into 2014, the consensus view was that U.S. bonds were on the verge of a major bear market and yields on 10-year Treasuries would end the year higher than their 2014 starting point of 3.03%.
Since then, 10-year yields have crumbled 15% toward 2.5%. Put another way, Treasury investors have taken a 15% cut in income. Bond investors invested in debt with maturities longer than 10 years have taken a similar income hit. These are the challenges of today’s income-starved bond investors, not to mention hidden credit risk and complacency. It’s up to alert advisors to help clients navigate these treacherous waters.
What Credit Risk?
Just three years ago, major credit raters like Moody’s and Fitch Ratings held steady on their view the U.S. deserved to keep its pristine credit score. But on Aug. 5, 2011 everything changed. On that fateful day, Standard & Poor’s downgraded the U.S. federal government’s credit rating from AAA (outstanding) to AA+ (excellent). It was a blow to the U.S. government’s reputation and the first time ever it was given a credit rating below AAA.
Instead of skyrocketing bond yields, which many analysts expected, the “penalty” for being downgraded was non-existent. The yield on 10-year U.S. Treasuries has been virtually unchanged at around 2.53% since August 2011, while yields on 30-year U.S. Treasuries has fallen 11.98% to around 3.36%. Deteriorating credit quality did not result in higher borrowing rates!
Furthermore, the U.S. government’s debt load has continued to ride higher, mushrooming from $14.9 trillion to $17.6 trillion over the past three years. The top three foreign holders of U.S. debt as of the second quarter were China ($1.26 trillion), Japan ($1.20 trillion) and Belgium ($366.4 billion). Again, despite increasing debt and deteriorating fundamentals, the bond market has shrugged off the risk.
Elsewhere, bond yields in even more fiscally challenged countries like Italy, Spain, and Greece have slid too—to levels that hardly reflect any concern about the possibility of imminent defaults. Italy and Spain pay just 10 to 30 basis points more on 10-year debt compared to similar maturing U.S. Treasuries! Compared to its global peers, the investment grade U.S. bond market has lagged the SPDR Barclays International Treasury Bond ETF (BWX) this year. BWX has climbed 5.66%, or double the return of the total U.S. bond market.
Is the rise of international bond prices and sliding yields a potential warning sign?
“I do feel that lower yields globally are, in fact, a signal that credit risk is being ignored,” said Joseph G. Witthohn, CFA and portfolio manager at Emerald Asset Management in Leola, Pa.
Strategic Opportunities
Despite dwindling bond income, the trend of falling yields and rising bond prices in 2014 has been a trading opportunity extraordinaire for Treasury bulls.
ETFs that benefit from lower yields and higher Treasury bond prices like the ProShares Ultra 20+ Yr. Treasury ETF (UBT) and the Direxion Daily 20+ Yr. Treasury Bull 3x Shares (TMF) have soared between 26% to 39% year-to-date through the end of June. Treasury bonds with long-term maturities (TLT) like those tracked by UBT and TMF are most sensitive to changes in interest rates compared to Treasuries (SHY) with maturities of less than 10-years.
Unleveraged ETFs that invest in long-term debt like the iShares 20+ Year Treasury Bond ETF (TLT) have gained around 12.5% since the beginning of the year, easily outperforming the SPDR S&P 500′s (SPY) gain of 7%.
When the dynamic of falling yields changes to a climate of rising yields, the opportunity for strategic bond trades will shift in the favor of bearish ETFs like the ProShares UltraShort 20+ Yr. Treasury ETF (TBT) and the Direxion Daily 20+ Yr. Treasury Bear 3x Shares (TMV). Both funds are designed to increase in value with 2x and 3x daily leverage when Treasury bond prices fall.
