Investors who buy bonds or bond funds are doing so because they want to reduce their risk and preserve their capital. Bonds work very well at doing this when the stock market or economy is declining, but not when economic conditions are strong.
Currently, the US economy is strong with 4% GDP growth, the S&P 500 coming close to setting a new all-time high, the unemployment rate at the lowest level its been in years. All of these indicators point towards the opposite of what bond investors want, especially the need for higher interest rates as inflation continues to creep higher.
Recently JP Morgan Chase’s CEO, Jamie Dimon, said he thought the 10-year Treasury yield should be at 4%, not where it currently sits at the below 3%. He went further and said that 5% interest rates are coming and that investors need to start preparing. Some have argued that interest rates should already be in the 4% to 5% range.
If, Dimon and others are correct in their prediction that higher interest rates are coming than current bond holdings need to “Get out of Dodge” before they get burnt. We have already seen bond funds take a hit in 2018, but if rates do climb as high as 5%, the losses we have seen thus far may dwarf what is to come.
Not surprisingly the best Bond Exchange Traded Funds over the past year are the 3X leveraged short funds. The iPath US Treasury 10-Year Bear ETN (DTYS) is the best performing ETF over the last year, up 41.84%, the iPath US Treasury 2-Year Bear ETN (DTUS) is the nest, up 30.79%, while the iPath US Treasury 5-Year Bear ETN (DFVS) is third best, up 28.13% over the last 12 months.
If we filter out the inverse and leveraged ETFs, the best performing fund over the last year was the iShares Convertible Bond ETF (ICVT) which is up 13.52%. Interestingly the second best non-leveraged ETF over the last year is also a convertible bond ETF, the SPDR Bloomberg Barclays Convertible Securities ETF (CWB).
What is interesting is that the best performing bond funds over the last year are all non-traditional bond funds. The three inverse Treasury funds clearly point out that the best way to play the bond industry this past year had been too short them simply. Even the Convertible Bond Funds have shown us that buying tradition bonds has not been the most profitable play this year.
So why have the bear funds handily outperform over the past year and why is it bad news for bond funds if rates do climb higher?
Well, the easy answer is because older bonds will be worth less money than new bonds issue’s that carry a higher interest rate. For example, if you own a five year AAA bond that has two years left until maturity which is paying 3% yield and I have a brand new two year AAA bond that is paying 3.5% yield, someone would be willing to pay more money for my bond than yours. They both have two years until maturity, but mine is paying a higher interest rate.
This example is exactly what happens when interest rates rise. Older bonds lose their value because new bonds with similar grades (AAA, Aaa, or whatever it may be) are offering a better interest rate. That makes the older bonds less valuable in the open market.
Now the value of your bond may not matter to you if you plan on holding it until maturity and collect the interest. But if you plan on selling the bond earlier, then the value is an important factor to consider when investing in bonds and bond funds.
Large bond funds typically don’t hold bonds until maturity, they buy and sell regularly, hence one main reason why they haven’t been performing well. But, over the past year, the leveraged Treasury Bear funds have crushed other bond investments because they are shorting the price of Treasury Bonds, which have been falling because newer, higher interest rate Treasury Bonds have been introduced to the market.
Interestingly though the Convertible Funds have also been outperforming others but again that’s likely due to the way these bonds are designed. A convertible bond can be converted into stock or the bonds price, and interest payment can be taken. For example, a $1,000 five-year bond paying 3% can yield the investor $1,030 after five years or say 100 shares of the company that sold the bond. If that companies share price is more than $10.30 (100 x $10.30 = $1,030) than the bondholder would convert the bond into stock and sell the shares on the open market. Thus, making more than the $1,030 the bond was going to pay out.
With a convertible bond, the price of the bond can hold its value better than traditional bonds even when interest rates are rising because the value of the bond can be determined by either the interest rate the bond is paying or the stock price of the company that issued the bond.
In a rising interest rate environment bonds aren’t usually the best investment, but as the bond funds above prove, certain bond strategies do still work.
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513
Disclosure: This contributor held long positions in Facebook, Apple, Amazon.com, Netflix, and Alphabet at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.