Bonds’ Two-Percent Warning

Football has its two-minute warning. Bonds have a two-percent warning. When it sounds, and the 10-year Treasury nudges past 2%, look out: Things are going to change, for the worse.

In professional football, the two-minute warning flashes when that much game time remain on the game clock, approaching the end of the second and fourth quarters. If the ball is in play when the clock reaches two minutes, officials call this warning immediately after the play concludes and declare the ball dead.

This month, the U.S. Treasury yield curve flashed a two-percent warning. Unlike in athletics, no one declared the bond market football dead and minutes later the game did not stop.

The legendary football coach, Vince Lombardi, was a stickler for fundamentals. When the Green Bay Packers lost to a team judged inferior, the next morning the dejected players had no idea of what to expect from their respected but feared coach. Announcing to the team that “we go back to basics this morning,” holding a football high in the air, strategist Lombardi yelled, “Gentleman, this is a football!”

While the now famous statement may seem sophomoric, it was brilliantly effective. So, without insulting your intelligence, kindly allow a review of fundamentals.

Since U. S. Treasury securities theoretically are immune from default or credit risk, the Treasury yield curve is a key benchmark for debt markets. Uncle Sam borrows money and issues IOUs backed by taxpayers.

Treasury bills cover terms of less than a year. Treasury notes are issued in terms of two, three, five and 10 years; Treasury bonds, 20 and 30 years. The yield curve is a graph reflecting interest rates paid on paper covering one month to 30 years. It appears in major financial and business mediums and on numerous financial websites. The yield on the 10-year note is widely followed as a harbinger of things to come. Are yields rising or falling, and what does that mean?

At the end of the 1970s inflationary bout, in 1981 the 10-year Treasury note hit a historical high of 15.84%. In a crisis-driven rush to safety, on Aug. 8, 2012, the rate hit an all time low of 1.394%. When interest rates decline, the value of a bond rises. Think about that.

Over more than 30 years interest rates trended down and bonds as an asset class benefited. Many financial advisors and investors experienced only a bull market in bonds, never a prolonged bear market. Since bond values drop as interest rates rise, complacency and recent experience can be dangerous.

 

For 11 days since Jan. 30, the 10-year Treasury closed at or above 2.0%. And until it slipped slightly below that level in today’s trading, the yield on the 10-year note topped 2.0% for eight straight days.

The trend is to the upside. Losses are reflected in bond mutual funds, exchange-traded funds (ETFs) and other fixed-income holdings. The bond game has not halted. But the 30-year bull market in bonds is dead, and the game is changing.

With any fixed-income holding, given falling interest rates in recent periods, don’t look at past performance as a guide in fund selection, especially in 401(k) and other retirement accounts. When interest rates rise, aggravated by inflation, fixed-income investing is not likely to grow future purchasing power on a net basis, after taxes and inflation.

At that point, meet with your financial advisor. Rethink your investment policy. Bonds as a defensive mechanism may require a change in strategy. What performed well over the last several years may not do so going forward.

As Coach Lombardi would say, a review of fundamentals is wise. How exposed are you to losses because of potentially rising interest rates? What is your money for? How long will it last given forecasted expenses, tax rates, inflation and your expected longevity?

What is your tolerance for risk (a.k.a., volatility)? Are you saving money or spending down your stash? Should alternative asset classes or defensive strategies be included in your asset allocation, as many large pension funds are doing?

Heed the two-percent warning. It’s a game changer.

 

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Lewis Walker, CFP, is president of Walker Capital Management Corp. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) in Norcross, Ga. Securities and certain advisory services offered through The Strategic Financial Alliance Inc. (SFA).  Lewis Walker is a registered representative of SFA, which is otherwise unaffiliated with the Walker Capital Companies. 770-441-2603. lewisw@theinvestmentcoach.com.
 
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