Is the Bond Bull Market Really Over?
By Jeff Korzenik, Chief Investment Strategist, Fifth Third Private Bank

Investors can go through a wide gamut of responses in their relationships with different assets. From an infatuation with technology stocks, a fling with options, and a flirtation with commodities to a divorce from exotic mortgage derivatives, market professionals have seen it all.

We even tried to reconcile with precious metals only to split again. While here at Fifth Third, our hearts belong to thoughtfully diversified portfolios, it is important to understand the changing relationships within an investment strategy. We think it is time to recognize that our thriving relationship with bonds – and the bond bull market that sustained us for three decades - is over. It is hard to imagine today that a 10-year treasury bond required a yield of over 15% in 1981 to attract buyers. As recently as last summer, investors so prized these same bonds that they accepted a return less than one tenth of 1981's levels. In light of this massive revaluation, we must reexamine the role bonds have played historically in investment performance, and even more importantly, to anticipate how that contribution might change in the future.

Bonds and us, we have a history
Bonds have long provided income and value, , returning regular coupon payments as well as a known amount at maturity. Along the way, these instruments historically lowered traditional stock and bond portfolios volatility -- typically being less subject to dramatic price swings than equities. In many poor stock market environments, bonds offered a counterbalance, moving higher as stocks signaled a weaker economic environment, or presaged bond-friendly monetary policy by the Federal Reserve Bank.

Over our multi-decade period of falling interest rates, bonds played an outsized role in generating favorable portfolio outcomes. Not only were early investors rewarded with extraordinarily high coupon payments, they also saw price appreciation as yields declined; double-digit returns abounded in the bond realm. No longer were bonds the realm of cautious "coupon-clippers," patiently collecting modest incomes. By the mid-1980s, even Wall Street no longer derided specialists in the field as "bond bores." As the decades progressed, investors no longer received the generous coupons of before, but nonetheless scored impressive total returns as yields continued to fall, adding capital appreciation that masked the reality of declining income.

A corner turned
Why should investors expect a different outcome today? We believe that the exceptionally low yields of July 2012 represented the end of the 1981-2012 bull market for bonds. The same forces that, heading in one direction, drove yields ever lower are now headed in the opposite direction.

The level of bond yields in the United States, over time, is driven primarily by three factors: 1) real economic growth, 2) inflation, and 3) Federal Reserve Bank policies. In our view, domestic economic growth is accelerating from sub-par levels to "less sub-par" levels. Similarly, we associate this pickup in activity with a similar inflation outlook, below average inflation modestly increasing to "less below average." Finally, we note that the Fed is poised to start trimming its aggressive asset purchase program. While none of these influences are particularly significant in and of themselves, the confluence of these drivers does support a strong case that bond yields are heading higher, and consequently, bond prices lower.

To proclaim yields are heading higher after our recent historic lows offers little insight of value. Critical to any developing any meaningful portfolio strategy is the need to define more than the destination of interest rates, but also the speed and duration of this path.

The journey to normal
We continue to believe that the U.S. economy is on a slow journey to normal. We define "normal" as an environment in which U.S. growth is more consistent with historic averages and reflects the potential of the economy. We define "normal" as a time when economic advancement is no longer hampered by the need to repay the excess indebtedness of the past, nor is the expansion of commerce overly reliant upon extraordinary monetary or fiscal stimulus from the federal government.

While we are far from the ultimate destination of a normal environment, we see signs that the economy continues to heal. Structural challenges surrounding the 2008-09 downturn continue to hold back rate of advancement, but the balance is shifting in favor of positive trends:

  • The U.S. housing market, a traditional driver of growth, is expanding and starting to feel the benefit of a ten-year demographic tailwind as the "echo boom" generation enters the workforce and establish households of their own.
  • After decades of sending manufacturing to China and other emerging economies, some production and associated jobs are returning to the U.S.
  • Breakthroughs in petroleum and natural gas extraction technologies have turned the U.S. into the world's largest energy producer, with positive impacts increasingly rippling throughout the economy.
  • Individual economies throughout the world are, with few exceptions, either stabilizing or growing, presenting a more favorable backdrop for U.S. business
  • Low inflation and high unemployment suggests that the U.S. Federal Reserve will exit its asset purchase program slowly and is many quarters and perhaps many years away from raising short term interest rates.

We need our space
In our current environment, bond investors must balance the fact that longer maturity of a bond, the greater the income, but also the greater the downside price risk as interest rates rise. The modest acceleration in growth implies that the increase in bond yields could be gradual and spread over many years. We view the 1950s as an analogous period, with average interest rate increases of only one quarter of one percent per year. In this scenario, our analysis suggests that intermediate maturity bonds best serve bond investors, achieving the appropriate balance between current income, risk, return relative to cash, and reinvestment opportunities. In a low inflation growth environment, corporate bonds, quality municipal bonds and international bonds all add benefit to portfolios, with the common admonition to avoid long maturity securities.

Critically, investors should readjust their expectations for bond portfolios. Low double-digit and high single-digit may well give way to low single-digit returns for the foreseeable future. To the degree bonds are a portion of a more broadly diversified portfolio, overall portfolio return expectations must be proportionately moderated.

Fortunately, the factors driving bond yields higher are also forces supportive of many other types of investments, most notably stocks. In the realm of equities, the accelerating global growth trends we anticipate, coming against a backdrop of ample, non-inflationary capacity, point to continued solid returns for shareholders. However, here too, we think investors are well advised to moderate their expectations. Shareholders of U.S. companies have benefited from valuation improvement as the U.S. exited the recession, converting solid earnings gains into double-digit price gains. However, such pricing shifts are cyclical, and while we do not believe that all domestic valuation opportunities are exhausted, we would expect them to moderate. We believe, European equities may be poised for the sort of outsized appreciation possibilities we have enjoyed in the U.S., and we are adjusting our portfolios accordingly.

Reconciling our relationships
The years ahead continue to hold attractive opportunities for investors. As we exit slowly from the economic dislocations of 2008-09, the journey back to normal has the potential to lessen the volatility and drama that has been such a challenge to maintaining a steady investment course. However, this period also represents a sea change in what we might be able to expect from bonds, and consequently the overall returns of broadly diversified portfolios. Ironically, this period of reduced, but still positive, returns coincides with an investment environment that may be generally more comfortable for investors.