Bonds, popular now, are due for a tumble

The financial crisis has admittedly had one side effect. Everything is now random, nothing is predictable and suddenly anything is possible.

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The financial crisis has admittedly had one side effect. Everything is now random, nothing is predictable and suddenly anything is possible. Take, for example, the future of bonds. Or more precisely, how things are likely to pan out in the medium term for the largest asset class in the world. The lowly bond far outstrips its glamorous cousin, equities, in daily trading volumes and market size.

This year has been a bumper year for the US bond market, the biggest on earth. Almost every member of the bond family racked up impressive returns for the year that ended on September 30. That includes: commercial mortgage backed securities (up 25 per cent); asset backed securities (up as much as 28 per cent); industrial grade bonds (gains of up to 25 per cent); emerging market (up by a third); and high yield (up by nearly half). Even the stodgy Treasury Inflation Protected Securities (TIPS) looked good with 10 per cent gains.

On the face of it, that appears a very good thing. In fact, you may even believe it is the start of a sustained bond market rally, especially as last year was the worst on record for bonds. Yet there was a reason for that eye-popping bunch of returns. The Federal Reserve had slashed US interest rates to their lowest ever and investors were frantically searching for yield. Stock markets are viewed by some as highly risky, mainly because prices in the past decade have been on a roller-coaster ride.

Hence money poured into bonds. About US$43 billion (Dh157.93) went into bond funds this year compared to a paltry $8.4bn invested in equity funds. US commercial banks were also a huge buyer of treasuries as they tried to make the assets side of their balance sheets look halfway decent. Of course, prices rapidly headed north as everyone rushed into the bond market. Now the Fed, in its intense desire to jump-start the moribund US economy, has been spending money like it is going out of fashion. First, there was the $700bn that George Bush junior approved in October last year under the "Let's Help Our Dumb Banking Chums Plan", also called the Troubled Asset Relief Programme (TARP).

Then there was the $787bn that Barack Obama signed off on last February that had a raft of benefits such as tax relief, infrastructure, education and so on. This easy money policy is probably working if the recent GDP stats are anything to go by. Yes, you will ask, what about the latest unemployment statistic, which is a horrendous 10.2 per cent and the highest since 1983? Well, typically there is a lag between economic growth and the unemployment figure, so that's not really alarming.

Also, corporate earnings and economic growth may turn out to be sustainable, and not just a flash in the pan. So here comes the bad news. When too much money chases too few assets, you end up with higher than normal inflation and the spending spree could mean that inflation may not be very far away. If there is one thing the Fed absolutely dreads more than recession it is higher inflation. Inflation, among other things, discourages investments and savings and pummels the hapless US dollar even more, which in turn makes imports frightfully expensive. The Fed has only one trusted weapon in its arsenal to battle the inflation dragon, namely tight monetary policy (translation - higher interest rates).

Bond prices are, of course, inversely related to interest rates. Higher interest rates will therefore mean lower bond returns. The Fed has also decided to cut back its purchase of treasuries. The recent news of India buying 200 tonnes of gold may signal the start of a trend where certain developing nations - read China - slowly lose their fondness for the dollar in general and US treasuries in particular.

I have frankly no idea exactly when the above scenario will happen. It could be July next year, or even later. The huge US household debt is the factor that will hold back any meaningful consumer spending and 71 per cent of the US economy is made up of what John and Jane Smith buy. The average American is still highly leveraged and saddled with an assortment of credit card debt, mortgage payments and auto and personal loans.

Absent a win at the Las Vegas tables or at the Kentucky Derby, consumers can spend only from three sources - earn more income, use savings or borrow more. Right now, people are repaying debt and/or saving, rather than spending or borrowing. The lacklustre job and housing markets are not helping, especially as $12 trillion has been wiped off peak home values since 2007. All this does not exactly set the stage for economic growth.

Still, it is a question of when, not if. At some point, when rates rise, it will dawn on bond investors that high yield is all very fine but not at the cost of loss of principal, which is what will happen when bond prices finally take a beating. So if you are bearish on bonds, what could you do? Well, typical bond portfolio strategies in such a scenario include reducing exposure to higher duration bonds, investing in bonds with a higher coupon rate and looking more closely at bonds with shorter tenors.

Another strategy is to "ladder" your portfolio, which is buying bonds with staggered maturities. This reduces interest rate risk and you also reinvest funds at higher rates from maturing bonds. Floating rate notes can also be added to the list, although you need to watch for poor credit quality. All this reduces the average portfolio duration and brings down the risk of losing value when your Bloomberg terminal finally flashes the news of rising employment and inflation.

Binod Shankar is a Chartered Accountant and a CFA Charterholder. He is a freelance writer and consultant and runs Genesis, a financial training company