Beyond Bond Basic
For those who might prefer a complete synopsis of a year’s worth of events rather than a week-by-week update, then this will provide all of you market lovers out there with a way to see the bond market’s overall performance in 2013. This article will sum up the bond market’s highs and lows of 2013 beginning with the 2nd quarter as Q1 was somewhat un-noteworthy. As some of you may know, the bond market had one of its worst years ever upon realization the Federal Reserve might actually start its tapering program (ending a policy of easy money).
In mid-June and towards the end of the second quarter, Ben Bernanke and the Federal Reserve issued a statement they might begin tapering. Now, for those of you who find the term “tapering” foreign, allow me to explain: about five years ago during 2009, after the entire financial system was on the verge of collapse, the Fed started a program called Quantitative Easing, knows as QE. In fact, around this time, when equities were declining, investors turned to bonds; but now, even with diminished returns, investors still maintain bonds as a relevant portion of their portfolio. Those who have read some of my previous articles will understand what QE is, and for those who have not, here is QE in a nutshell: the QE program is a massive bond-buying program where the Fed buys $85 billion worth of treasury and mortgage debt every month in order to keep interest rates low. Now, the reason interest rates stay low is because the more bonds that are purchased, the more money is flowing through the economy courtesy of a large buyer. Thus, when the Fed revealed its intention to “taper” its QE program, the bond market reacted perversely and violently (i.e.—the large buyer was going away).
Economies and markets abhor rapid, drastic changes, as they need time to adjust, so when they are forced to make whatever necessary adjustment, they do so in a volatile manner, rather than a healthy and gradual movement. An analogy would be like revving a car all the way up in neutral, then banging the transmission into drive rather than slowly accelerating in drive in the first place; the car will accelerate and react quickly and violently as it adjusts to the sudden and extreme shift, rather than accelerating smoothly in drive. The markets work on the same premise; on June 19th, 2013, the Fed revved up the engine on the bond market then banged the transmission into drive. The bond market reacted so violently, it resulted in none other than a massive selloff. Yields on all bonds, including treasuries, corporates, mortgages and munis, rose to multi-year highs; traders and firms accrued large losses as a result. The 10 year US Treasury bond was trading at nearly 4.00% in 2009, fell to below 1.50% in May 2013, rose to 3.00% at the end of 2013 and has settled in the high 2.00% range (most recently 2.84%).
In the ensuing weeks after Bernanke began to realize and witness the implications his statement was having on the bond market, he issued a follow-up statement the Fed would delay its tapering due to a lower-than-predicted unemployment (new jobs created) report. Considering the unemployment report reflected fewer jobs were created than expected, Bernanke and the Fed had no choice but to continue to stimulate the economy. The Fed has found no real, feasible opportunity to start its tapering on QE, but rather vaguely suggested it will start by the end of 2014. Since the panic of June, as per the treasury yield bounce-back to a lower level (2.00%), yields have stabilized due to assurance that the Fed will postpone tapering. The yield stabilization bodes well for earnings in 2014, but still leaves a lurking fear as to the enigmatic situation the bond market will undergo when the Fed does finally decide to taper. Despite this, the Wall Street Journal opines bonds will always be an integral part of any investor’s portfolio, as they, despite public perception about high yields, are a secure and virtually fool-proof investment.