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One thing has seemingly not changed over the almost forty years of the bond bull market: investors really do not understand how bonds work.

Correction Over Reexamined

October 27th, 2021 by Kurt L. Smith
  • No, I am not referring to recent stock market activity, but hopefully I got your attention. Since July’s letter “Correction Over” bonds have performed poorly, as expected. While the bond market’s poor performance has yet to rub off on other markets, it would be a mistake to ignore what is unfolding.

    Interest rates are rising and not just a little. I continue to watch the bellwether US Treasury bond, the 2.375% of November 15, 2049, which traded at 113 back in July when I wrote “Correction Over” (yields and prices per Bloomberg). This past week the bond traded at 105 for an 8-point loss over three months.

    The ten-year US Treasury note, the 1 ½% February 15, 2030, traded at 103.75 (1.04%) in July and 99.25 (1.60%) last week for a 4.5-point loss. But it was the five-year US Treasury note, the .25% of August 31, 2025, which really moved from .63% in July to a doubling to 1.25% last week. Those five-year treasuries traded over 100 in September 2020 and last week traded at 97 (1.04%). Originally buyers of this short, five-year note, have seen twelve years of income in market value evaporate over the past fifteen months. Thank goodness the note will mature at par, though in 2025!

    Long-time readers know we advocated moving out of bond funds in my March 6th letter published March 30, 2020. March 6th, I believe is quite consequential and bond market performance since then continues to disappoint bond bulls and reward bond bears.

    There are no doubts US Treasury yields, as well as most if not all bonds, remain low. To say borrowing now, at today’s yields, is not worthwhile borders on the preposterous. Yields are low and that benefits sellers of debt. For buyers of debt, I believe it to be the complete opposite.

    As owners of the bellwether thirty-year US Treasury bond may attest, losing forty points of market value is not enjoyable. For owners of the five year treasury note, their only safety appears to be at maturity as they have seen  twelve years of coupon earnings erased over the past fifteen months.

    One thing has seemingly not changed over the almost forty years of the bond bull market: investors really do not understand how bonds work. Many investors have relied on conventional wisdom and have, 20%, 30%, 40% or even 50% of their investments in bonds. Whether this was for diversification purposes, the fact remains both stocks AND bonds have traded at their all-time highs over the past twenty months. And you know which one no longer is not.

    One would think others might be able to figure out that the trend for bonds is toward lower prices and higher yields. Even investors in supposedly short and safe five-year bonds could have, should have, seen the risks in buying such high priced and low yielding bonds. But obviously that did not prevent them from doing so because that is where they traded in the past and that is now water under the bridge.

    Bond investors seem to be willing to put up with assuming large interest rate risks for little yield. This, I believe, is because investors continue to misunderstand how bonds work. Most investors have not experienced a bear market in bonds and the last time they did the entire market value for bonds and other debt was a fraction of what it is today.

    Bond markets matter and the reason they do is because investors own so much of the stuff. Individuals, companies, and governments continue to issue bonds because the interest rates are low (and favorable)!

    The question is why do investors continue to buy? Doing nothing is doing something because your bond market manager is continuing to buy more as bonds mature. Market values also decline, sometimes greatly. Owners of fixed income funds will continue to lose as the trend towards higher interest rates continues.

    One would think bond investors are smart people. I am sure they are. But I doubt they know much about bonds, particularly about risks and rewards. If the market is so smart, why did the bellwether sell-off forty points. And if one thought short-term five-year bonds were a good idea at next to nothing yields, then I wonder whether bond math is their thing.

    Remember, I continue to believe we are in a trader’s market for most assets. That is, you better know how to sell because a forty-point loss can happen at any time to any asset. Continue to be careful out there.

    Texas State Water Development Board

    State Revolving Fund Revenue Bonds, New Series 2021

    AAA S&P Underlying   AAA Fitch Underlying

    Due 8/1   Dated 11/4/21 Maturity 8/15/41

    $386,155,000 Sold

    Years   Maturity            Coupon      Yield*

    1             2022              3.00%           0.13%

    2            2023              4.00%           0.21%

    3             2024               5.00%           0.29%

    4           2025              5.00%           0.43%

    5             2026           5.00%           0.59%

    6            2027           5.00%           0.75%

    7            2028           5.00%           0.92%

    8            2029           5.00%           1.07%

    9             2030            5.00%           1.21%

    10           2031            5.00%           1.29%

    11           2032**         5.00%           1.34%

    12           2033**         5.00%           1.40%

    13          2034**         5.00%           1.44%

    14          2035**        4.00%           1.62%

    15          2036**        4.00%           1.67%

    16          2037**         2.25%           2.27%

    17          2038**         2.25%           2.32%

    18           2039**         2.25%           2.36%

    19           2040**         2.375%          2.40%

    20          2041**        2.375%           2.44%

    *Yield to Worst (Call or Maturity) ** Call 8/1/31

    Source: Bloomberg

    This is an example of a new issue priced the week of 10/11/21

    Prices, yields and availability subject to change

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