After enduring years of the Federal Reserve’s zero percent interest rates and trillions worth of long-term bond purchases meant to drive widows and orphans into riskier assets, many investors capitulated, reaching for yield in long bonds and other risky assets. You can see the tracks of this behavior in the stock market as well as the bond market.
In the bond market, the reach for yield may have climaxed over the summer. The 30-year bond yield hit a low of 2.11% on July 8th. That is lower than the lowest-low during the height of the financial crisis.
What were these investors thinking lending the government money for 30 years at only 11 basis points above projected inflation?
I can’t give you first-hand knowledge of their thinking because at Young Research and in Richard C. Young & Co., Ltd.’s managed accounts (we provide exclusive investment research to RCY Ltd.), we kept maturities short.
That wasn’t the easy trade. Especially in July and August when the long-bonds were up nearly 20% on the year compared to single digit returns in short-maturity bonds. Wall Street of course jumped on the momentum bandwagon after the long-duration trade paid off (and no sooner) and started advising clients to extend maturities.
We listened to the pitch, but didn’t see the opportunity. I would like to tell you we kept maturities short because we were forecasting a Trump victory and a rise in long-term bond yields, but that wouldn’t be true. We kept maturities short not because we knew when and why long-term bond yields would rise, but because we saw no margin of safety in long bonds.
Yields were at 5,000 year lows and the bet everybody wanted to make was that rates were going to fall further. Maybe this trade would work out, but in our view, there was an even bigger probability that it wouldn’t. If rates normalized, even at a lower level, this trade had to blow-up.
Over the last few weeks, that is exactly what has happened. From its July low, the 30-year bond yield has risen almost a full percentage. Our chart shows that the Merrill Lynch 30-year Treasury index is down almost 17 percentage points from its July high (low point for yields).
Long-bonds aren’t as unappealing as they were in July, but the risk-reward still warrants caution.
Jeremy Jones, CFA
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