Why Bond Yields Aren’t Going Up

The Dow Jones industrial average is down 415 points when bond sage Sreeni Prabhu declares over the phone that “stock market volatility sure does help fixed income.” Although he believes the Federal Reserve’s plan to finally take short-term interest rates off rock bottom is correct, Prabhu doesn’t worry that such a move will torpedo the bond market. In plain language, he’s convinced that no matter what the Fed does with short-term rates, long-term rates aren’t going to change much because investors are so concerned about turmoil in the stock market. (Prabhu’s best idea, incidentally, is mortgage-backed securities, both government-backed and so-called non-agency securities. DoubleLine Total Return Bond (symbol DLTNX), a member of the Kiplinger 25, invests in both kinds.)

An hour later, with the Dow off 385 points, I ring up Kansas City bond strategist Dan Heckman. He seconds Prabhu’s view that no matter what the Fed does, bond yields will remain flat or even dip a bit because “volatile stock markets create a floor that supports bond prices” (bond prices and interest rates move in opposite directions).

One reason the Fed’s long-anticipated hike, the first since 2006, probably won’t sink bond prices is that the Fed isn’t really tightening credit; it’s simply reclaiming some of the extreme stimulus measures it used to combat the Great Recession. Beyond that, inflation, the great enemy of bondholders, is almost nonexistent, and demand remains strong for Treasuries and other high-quality, dollar-denominated, income-paying assets.

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And then there’s China. Prabhu, chief investment officer for Angel Oak funds, and Heckman, who works for U.S. Bank, have crowned China as the best friend of U.S. bond investors. The downshift in growth and other economic stresses in the world’s second-biggest economy buttress my contention that rates on high-quality medium- and long-term bonds in the U.S., Europe and the rest of the developed world will move little in the foreseeable future.

Worrywarts will always see disaster behind the headlines. The China horror movie goes like this: The country is a house of cards, full of zombie companies and insolvent banks. To rescue these walking-dead firms and buy social peace by paying wages to millions of people working at unnecessary jobs, the crony Communists in Beijing will cut purchases of Treasuries and draw down China’s $4 trillion in hard-currency savings. The U.S. Treasury won’t be able to find other big buyers to finance our debt, so T-bond prices will drop and yields will ascend. Main Street will join Wall Street in the soup as fear spreads that the days of affordable mortgages and cheap business credit are just about over.

Minimal impact. I don’t buy the doomsday scenario. The Chinese stock market is a manipulated joke. Although its economy is a force, China accounts for only 1% of our exports. Moreover, compared with almost every other place in the world, the U.S. is cooking. Gross domestic product in the U.S. grew at an impressive annualized rate of 3.7% in the second quarter. Kiplinger expects growth of 2.5% for all of 2015 and 2.8% in 2016. And this is being accomplished with almost no inflation.

It’s true that the U.S. bond market wobbled a bit over the summer, with the yield on the benchmark 10-year Treasury bond rising to 2.5%. For a while, all major bond categories briefly showed negative year-to-date returns. But as soon as China lit the stock market fire, the 10-year Treasury yield fell below 2% again. As of September 7, the 10-year yielded 2.1%. Look for the yield to stay in a narrow range the rest of the year. And if that happens, your bonds and bond funds will end 2015 in the plus column. Can’t say that about your stocks.