Demand for U.S. government bonds is on the rise, raising the question of whether that signals a pullback in the stock market, which is near all-time highs.
Since mid-March, the 10-year Treasury yield has fallen from more than 2.6 percent to around 2.4 percent. The 30-year rate has dropped. Because bond yields move inversely to their prices, the falling yields indicate that there is more demand for bonds and their prices are higher.
People are buying Treasurys because they don’t think interest rate hikes will be as dramatic as what they previously thought, says Jay Sommariva, a Fort Pitt Capital Group senior portfolio manager who focuses on fixed-income accounts.
[See: 7 Horrendous Dividend Stocks to Actively Avoid.]
Investors are also turning to bonds because they want the safety they offer in light of geopolitical issues including tensions over Syria and worries about Europe, he says.
“It seems like there’s a safe-haven [play] of people going back into bonds,” Sommariva says.
Patrick Kaser, a Brandywine Global Investment Management portfolio manager who focuses on equities, says some bond investors are betting on lowered inflation expectations. Others think that the drop in bond yields is simply a technical pullback after yields shot higher from a low of roughly 1.4 percent last year, he says.
Some investors may be switching out of stocks and into bonds because they think the equities rally may be ending, Sommariva says.
But more of the move into bonds is probably driven by large pension funds and institutional investors who are trying to to keep their portfolios balanced at 60 percent stocks and 40 percent bonds, he says. Because of the gains in stocks, these investors are having sell equities and buy bonds simply to rebalance their portfolios, he says.
Sommariva says the demand for bonds could be showing that there is “a little bit of frothiness” in equities.
But Kaser says what happens with bond yields doesn’t necessarily signal bad news for stocks or the economy.
Yields for longer-dated bonds typically are higher than those for bonds of shorter maturities because of inflation expectations. The difference starts to narrow when people think longer-term inflation is less of a risk, which can happen when there is less economic growth.
But just because the bond yield curve flattens, doesn’t necessarily mean bad news for the economy, Kaser says. It’s only an inverted yield curve that’s truly problematic, and a flatter curve doesn’t necessarily mean the curve will invert, he says.
Kaser says the current bond market bets on lowered inflation expectations are wrong, and he expects yields will move higher toward the end of the year. He points to the strong U.S. labor market where wages are rising. He thinks oil prices will move somewhat higher toward the end of the year. And he thinks the Federal Reserve will raise short term rates by up to 50 basis points over the course of 2017.
The Fed also could curtail its purchases of bond market securities, he says. That would remove a buyer from the market, which should cause prices to sink and yields to rise, he says.
[See: 8 Times When You Should Sell a Stock.]
How should investors play these market dynamics? Some retail investors still haven’t totally re-entered the market since taking a beating in 2009, Sommariva says. With stocks near all-time highs, now might not be a great time to put everything back into equities, he says.
For fixed-income investors, there isn’t a good time to try to time the bond market, he says. But in general, for people who are in a high tax bracket, he recommends putting large chunks of a portfolio in municipal bonds. He prefers general obligation munis to revenue bonds because they are generally safer.
For those who want to park excess cash and get a better rate than a certificate of deposit or money market account, Sommariva recommends laddering 1- to 6-year corporate bonds to take advantage of potentially higher rates in the future. Make sure to buy in different sectors, he advises.
Turning to stocks, Kaser thinks there are some groups of equities that will perform well as yields rise.
With rising bond yields, investors are likely to exit highly priced bond proxies such as utilities, real estate investment trusts, consumer staples and telecoms, Kaser says. “It’s not hard to envision those stocks falling 15 to 20 percent,” he says.
Instead, investors are likely to favor financial stocks and some commodity related names if bond rates resume an uptrend later this year, he says. That’s because banks earn more money when bond rates rise, and commodities producers tend to do better amid the inflation that comes with economic expansion and more demand for raw materials.
In this scenario he likes banks such as Citigroup (ticker: C), JPMorgan Chase & Co. ( JPM) and Bank of America Corp. ( BAC) because they tend to see net interest income rise faster with Fed interest rate hikes than do regional banks.
[See: The 7 Best Bank Stocks to Buy for 2017.]
On the commodities side, Kaser likes Canadian Natural Resource and Devon Energy Corp. ( DVN) because they will likely benefit if oil moves north of $60 a barrel like he is expecting.
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Here’s Why Government Bonds Are in Demand originally appeared on usnews.com
