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What’s up with bonds this year?
By Henry Herrmann, Chief Investment Officer
Waddell & Reed, Inc. |
Amidst all the talk surrounding the economy, inflation, and interest rates over the last nine months, something unique in recent market history has happened. In an unusual twist, bonds, broadly defined, are outperforming the stock indices year-to-date.
Who would have believed that bonds would have done well — much less outperformed stocks — during a period when the economy was accelerating, inflation was rising modestly and corporate profits were strong? I, for one, am not terribly surprised that bonds are doing well, mostly because they had such a lousy year in 1999
Last year, in fact, was one of the worst years for bonds over the last 20-year period. Why did bonds fall out of favor? I attribute this to two primary factors: first, it was commonly believed that the Federal Reserve was going to raise interest rates dramatically. Second, inflation, many said, was poised to increase significantly. Both, if true, are big negative influences on bond prices. In retrospect, the first point was only partially correct and the second one hasn’t really come to pass at all.
Concerning the first point — interest rates — the Fed has raised them, but they have not been overly aggressive in doing so. The second point — inflation — hasn’t become a problem at all. Yes, inflation has risen from its very low point, mostly due to the increase in energy prices. Once you look past energy, however, there are not a lot of inflation concerns. The Consumer Price Index the broad measure of inflation, is currently at less than three percent. This is above its low of two percent last year, but it is hardly going through the roof.
So, at this point, investors’ anxieties have not been reinforced with reality. It is this recognition that is, in my opinion, causing bonds to do better, especially lately. My personal methodology for evaluating bonds is to look at the “real rate.” In other words, what is the difference between current interest rates and the inflation rate? Current high-quality bonds yield around seven percent and the inflation rate is roughly three percent, giving us a real rate of four percent, which is high by historic measures. High real rates usually indicate an opportunity.
Six months ago, real rates were a full point above where they are now. This opportunity, however, was only realized when inflation statistics remained tame this summer. When the inflation fears then began to diminish, bonds started to do better. In August, the Federal Reserve chose not to raise interest rates, and they deferred again in October.
Going forward I think it’s clear that the economy is slowing. I’m not certain the Fed is done raising interest rates, but it certainly looks as if that is the case. If there are any further indications that rates will stay static, then the bond market should begin to reflect on when the ease is coming. This, in my estimation will be sometime in late winter or early spring.
This all suggests to me that we have a further rally on the horizon. I don’t see any reason, on a long-term basis, why real rates shouldn’t be lower than they are today. High-quality bonds yielding six percent, I think, is plausible.
Regardless of magnitude I believe that bonds still look under-priced. So for the risk-adverse investor, or as part of an asset allocation program, I continue to believe that bonds are a good alternative. |
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