4 reasons why investors should be careful with bonds

At the beginning of the year, almost every expert who made a prediction on the bond market had a negative outlook. It seemed like a no-brainer at the time. The U.S. economy was on the mend, which meant the Federal Reserve would continue to taper its asset purchase program, and then eventually raise interest rates.

However, despite the fact the economy has shown improvement this year, despite the weather-related first quarter gross domestic product report, and the Fed indeed tapering its asset purchase program, interest rates have dropped and bonds have performed well.

So, what’s going on? The answer to why bonds have actually rallied this year, rather than declined, as many predicted, is interesting. Furthermore, bond bears shouldn’t back down from their bond predictions. Based on what’s happening, I believe the fundamental case for bonds having a poor long-term forecast has only strengthened.

1. Who are the bond buyers? At the end of the day, asset prices move higher when investors demand an investment in excess of what is supplied. One commonly overlooked characteristic of today’s U.S. Treasury market is that there has actually been an incremental decline in the supply of U.S. government debt this year, due to lower deficits. Additionally, the demand for U.S. Treasuries is rising higher, even as the Fed tapers its purchases. Last year, after the Fed announced its intentions to buy fewer U.S. bonds, the currencies of many countries declined quickly and severely.

For many nations, a lower currency isn’t desirable and has negative implications for their economy. In order to combat this occurrence, foreign nations have opted to intervene by purchasing large amounts of U.S. debt, which helps suppress the rise of interest rates, and in effect the borrowing costs of those nations. Also, as interest rates plummet to rock bottom levels in other developed countries, U.S. yields have become relatively attractive. This led to a large increase in the purchases of U.S. government bonds from institutional investors and governments around the world.

However, investors should heed caution, because private or government purchases or sales of U.S. debt can change direction quickly and without notice. Although U.S. Treasuries have found a substitute buyer to replace the Fed, these new buyers will likely be far less dependable and predictable. In effect, the quality of buyers in the market for bonds has declined considerably this year.

2. Inflation won’t stay low. So far in 2014, the U.S. economy has had a perfect Goldilocks combination of improved growth without much inflation. This has helped keep interest rates low as the Fed remains accommodating with its monetary policy. However, if we’re assuming the U.S. economy continues to improve, inflation is inevitable. Most of the reason why we haven’t seen inflation is stagnant wage growth.

However, as the slack in the labor market disappears, we will eventually see wages rise. We’ve already started to hear about employers across the country having difficulty finding quality workers at the wages they’re offering. Although predicting exactly when wage inflation will pick up is impossible, it’s difficult to envision an environment where wage growth remains suppressed as economic growth continues to accelerate.

3. The Fed’s reaction. Once inflation begins to rise, there won’t be any additional rationale for why the Fed would keep interest rates at record lows. Furthermore, if inflation becomes too high, you could even begin to see the Fed start to unload its massive balance sheet. Sure, the Fed has stated it could hold all of the $4 trillion worth of assets it accumulated to maturity.

However, should inflation reverse and become a problem, it would absolutely be an option for the Fed to begin exiting some of assets it currently holds. Though I don’t think this is a probable outcome, bond yields seem to be pricing in a zero percent chance of this happening. I believe bond investors are being a bit complacent in this regard, and could be underestimating how the Fed would react should we experience an unexpected elevation of inflation.

Granted, a buy-and-hold bond investor can stomach price volatility as long as they’re confident the bond issuer will return the entire principal at maturity. But with the 10-year Treasury yielding a mere 2.4 percent, it won’t take much inflation to erode away that minuscule return.

4. Everyone else’s reaction. Like anything else in finance, momentum matters. Right now, the momentum is positive for bond investments. For all the reasons we’ve mentioned, bonds have been a rewarding place to invest for many years. However, should bonds begin posting negative returns, it’s likely you’ll begin to see active money managers react to the unattractive performance by reducing or exiting their positions. As we’ve witnessed before on countless occasions, the pendulum can swing quite drastically in the wrong direction for a considerable period of time.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth may not develop as predicted. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Brett Carson , CFA, is the director of research for Carson Institutional Alliance where, as portfolio manager, he is directly responsible for managing several strategies, including perennial growth, long-term trend and write income. Additionally, the Omaha-based research department conducts thorough analyses of companies to identify undervalued stocks that carry attractive upside potential.

Investment advice offered through CWM, LLC, a Registered Investment Advisor. Securities offered through LPL Financial, Member FINRA/SIPC. LPL Financial is a separately owned entity from all other entities.

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