A Tipping Point In Bonds?
A 27-year-long bull market in bonds is over and a brutal bear market is under way, says Tom Atteberry, co-manager of FPA New Income (symbol FPNIX). That's bad news for bond investors, particularly those holding Treasuries and municipal IOUs.
Atteberry, who spoke with us at the annual Morningstar Investment Conference in Chicago, says there's good reason to believe that the run-up in Treasury yields that began late last year will continue. Between December 18 and May 28, the yield on the ten-year Treasury has zoomed from 2.04% to 3.67%. That has led to big losses for holders of Treasury bonds because bond prices move inversely with yields. Year-to-date through May 28, the Barclays Capital US Treasury 10-Year Term index has lost 7.9%; an index of Treasuries with maturities of 20 years and longer has plunged 22.2%
Atteberry says he's seeing anecdotal evidence that Chinese investors, huge holders of Treasuries, are beginning to sell their government-bond stakes. "They are very, very nervous" about the Federal Reserve purchasing Treasury debt because of the move's potential for stoking inflation, one of the prime enemies of bond holders.
The arguments for the sell-off in bonds are well known. The U.S. is issuing an enormous amount of debt -- Pimco bond guru Bill Gross estimates that gross issuance in 2009 will total $3 trillion. And eventually, once the deflationary undertow of unemployment and slack capacity in the U.S. weakens, inflation will move front and center in the minds of investors.
View those assumptions against the backdrop of the terrific bull market in bonds over the last few decades -- the yield on the ten-year Treasury peaked at nearly 16% in 1981 -- and you'll start to share Atteberry's anxiousness. "This spells secular bear market," he says. "The good times, in bonds, are behind you."
Atteberry's thesis spells trouble for municipal bonds, which analysts have been pointing to for months as attractive alternatives to Treasuries. Interest from muni bonds is free from federal taxes, and the sector historically has seen extremely low default rates. Thanks to those benefits, munis have historically offered about 80% of the yield of Treasuries.
As munis were pummeled during the panic of 2008, they at one point offered twice the yield of Treasuries, making them even more attractive than usual. As long as munis offered a substantial yield cushion over Treasuries, they didn't necessarily stand to suffer from a rise in government-bond yields.
But as bond investors regained their appetite for risk in 2009, they pushed up muni prices -- and pushed down their yields -- to the point where that cushion has essentially disappeared. As of May 22, the yield on ten-year triple-A-rated municipal bonds had fallen to 81% of the yield on the ten-year Treasury.
"The ten-year part of the muni yield curve will probably track the ten-year Treasury" from here on, says Hugh McGuirk, head of T. Rowe Price's municipal bonds department. That suggests that if Treasury yields continue to rise, muni yields will rise in lockstep, causing their prices to fall roughly in tandem with Treasuries.
Atteberry, meanwhile, finds little in the bond market to be compelling. He points to a recent increase in corporate-bond issuance as evidence that executives expect their borrowing costs to head higher. And, still concerned about the health of the U.S. economy, he is avoiding high-yield, or junk, bonds.
He likes selective mortgage backed-securities that he thinks could weather a rise in rates without losing money, in addition to the debt of government agencies, such as the Federal Home Loan Bank. And he's still holding on to a giant wad of cash-recently totaling about 21% of fund assets.
If Atteberry is wrong, his missteps will be well exposed in FPA New Income, which he will be piloting solo in 2010 as co-manager Bob Rodriguez goes on sabbatical. And if he's right? "It's going to be pretty ugly."