Schafer: As Inflation Looms, The Bond Run Ends And Investors Scramble

Star Tribune (Minneapolis, MN)

Investment analyst Michael Batnick, blogging at the Irrelevant Investor this week, posted what he called the most important chart of the decade.

It had nothing to do with stock prices.

It showed the personal savings rate going back to 1960, and what leaps off the page is how Americans stashed so much money away in the terrible pandemic year of 2020 that it was easily the 60-year high in the U.S. personal savings rate.

That wouldn't happen in a normal recession, but that wasn't really his point. He was trying instead to imagine what will happen when all the money starts getting spent.

Prices just might be going up for many of the things we buy.

This prospect for renewed price inflation — a non-story for so long that even baby boomers may have put it out of their minds — has been making the stock market choppy.

But it's been a far rougher time in the bond market. And that could eventually mean a lot for the real world of saving and borrowing money.

The yield or interest rate on the 10-year Treasury note, a bell cow in the vast bond market, went from about .9% at the start of the year to about 1.5% this week. That's a very big and very bearish move.

"As a bond manager, we are scrambling to come up with strategies just to preserve principal," said Bryce Doty, senior vice president with Sit Fixed Income Advisors, LLC of Minneapolis and a senior manager of taxable bond portfolios. "Were not so naive as to think we're going to have a significant positive return" in 2021.

"It's over," he later added, of the 40-year bull market in bonds.

That's a remarkable thing, the end of a such a long market trend.

If an investor bought the 30-year Treasury bond in the fall of 1981 when interest rates were peaking, all they would've had to do was take a three-decade nap and earn more than 15% a year the whole time, more or less risk-free.

Bonds don't usually perform that well, but they rarely cause losses. Because a bond is basically a form of a loan, though, one way to lose money is making a loan that doesn't get paid back. Another way to go backward is for interest rates to shoot up.

Rates and bond values go in opposite directions. When yields rise on the 10-year Treasury note, that sounds great, right? It sounds like owning that bond must be more profitable.

Well, no, it's not great. If you own bonds that pay an average of 1% and interest rates on new ones jump to 1.5%, then the old investment isn't worth as much.

The Bloomberg Barclays U.S. Aggregate index, sort of like the bond market's S&P 500 Index, currently has about a 1.5% annual yield. If interest rates increase one percentage point this year, an investor will lose about 6% of principal value as the price of the bonds decline. That will swamp the 1.5% in income.

Inflation is a factor with any investment, but it's really important to the bond market.

If you loan a friend $1,000 and expect to get paid back with interest, first you got to make sure you charge enough interest to end up with the same purchasing power you had when you loaned the money. If prices rise 3% during the period of the loan, then charging just 3% to your friend won't really give you any return.

Doty said he might be more pessimistic than the current consensus about the direction of the bond market. What stood out in our conversation was his explanation of the effects of $7 trillion committed in the U.S. by various government entities to withstand the economic crisis brought on by the pandemic.

"The money has to go somewhere," Doty said. "And it's going everywhere, all at the same time."

Single-family housing prices have increased, crypto currencies like Bitcoin have been on a tear, oil prices have moved up and so on.

The pandemic was brutal for some types of service businesses, as some restaurants have closed, airlines have idled planes and let go of staff and so on. That means there's going to be a tighter supply of some of these things just as the virus finally fades and demand really picks up.

"You'll wait a month to get into a restaurant, pay 50% more than you did a year ago and be happy to do it," Doty said.

The increase in interest rates he expects is all about inflation heating up. He's looking for the 10-year Treasury note yield to end the year between 2.5% and 3%, up from about 1.5% this week.

Some ideas of what to do with money besides bonds include buying stocks in companies that will gain from the return of a more normal economy. There are also bond funds that have a lot less interest-rate risk. Sit has an exchange-traded version literally called VALT, which is benchmarked to bonds of durations as short as one month.

Doty suspects the inflation surge won't last all that long. But traditional bond investors won't have much fun in the meantime.

He remembers what happened with his company's U.S. Government securities fund, which for years never had an annual negative return. But in 2013, during what became known as the "taper tantrum," a jump in interest rates after a signaled switch in Federal Reserve policy, the fund posted a small annual decline.

"And we saw half a billion dollars go out of that fund pretty quickly," Doty said. "People were so angry. And we were one of the best-performing funds!"

In 1994 the main bond index showed a negative annual return for the first time since it got launched in the 1970s, making the 1994 bear market in bonds the worst in recent history. This year, Doty said, could be worse.

"So many people use have used bonds as the anchor of their portfolio," Doty said. "And I'm like, 'Yeah, it's going to be an anchor all right.'"

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