Investors tend to follow the herd.  This is especially true when the trend the herd is following is paying off.

Bucking the trend is more difficult. This is true despite whether markets are in an uptrend or a downtrend. As money managers, we tend to view prevailing trends with a healthy dose of skepticism.

After all, even the most popular and profitable investment trends inevitably reverse course at some point. Where many investors fail, however, is that they tend to spend too much time trying to figure out the exact timing of these shifts in trend. Not only is this difficult to consistently pull off, even for professional investors, but it’s largely unnecessary and generally costly.

Remember, as investors our choices are not just limited to binary buy or sell decisions. We can also simply choose to avoid a particular investment market altogether when our analysis tells us there’s not much potential ... when the expected return just doesn’t justify the risk.

The market for long-term bonds looks like a perfect case in point right now.

The Wall Street Journal dubbed it “The Great American Bond Bubble” last year.

Perhaps they were a bit early on their forecast. Long-term Treasuries continued to perform well this year. The Barclays Aggregate Bond Index, which tracks mainly US government bonds, is up 7 percent year-to-date, while the S&P 500 Index is up just 1.8 percent.¹

In fact, over the past five years, the Aggregate Bond Index has gained 6.14 percent per year on average, beating the S&P 500’s annual return of -0.18 percent by a wide margin.²

Not surprisingly, investors are chasing bond performance. Bond funds have enjoyed record inflows of more than $735 billion from 2009 through October 2011 — far outpacing the amount invested in domestic and global equity funds over that period.³

But if you are among those staking a claim on long-term bonds now, think again. In our view, investors may be making this massive asset allocation move at precisely the wrong time. After all, if we can be certain of anything in today’s volatile markets, long-term bonds, especially US Treasuries, offer little long-term value at today’s lofty levels and with yields at record lows.

This Trend Is NOT Your Friend

If you take a closer look at the source of fixed income returns over the long term, you’ll notice it’s the coupon yield you receive that is the most important factor in determining your total return. From 1926 through 2009 for instance, intermediate US government bonds produced a total return of 5.3 percent per year on average. Most of this gain — 90 percent of it to be exact — came from the annual yield of 4.8 percent on average over the period.⁴

In other words, you can’t count on much in terms of capital appreciation over the long term.

Understanding this concept is critically important today because the starting point for yields can make all the difference. With 10-year Treasury bonds offering paltry yields of just 2 percent today — near record low levels — it is not a good starting point for fixed income investors. Take a look at the graph below, which vividly shows two very different experiences for bond investors.

Starting on the right side of the graph, you’ll see the great bond bull market that began after interest rates peaked in 1981. Since then rates have declined steadily for more than three decades now, boosting total returns to 11.3 percent for the 10-year Treasury index.⁵

Notice this total return is much higher than the average coupon yield of 6.9 percent over the period, meaning income was enhanced by persistent gains in bond prices as interest rates declined. In fact, with yields so low today, Treasury bond prices have soared to bubble-like proportions.⁶

On the left we see a much more sobering view of a bond bear market — declining bond prices as interest rates rose.

The period of rising interest rates from 1950 to 1981 produced annual total returns of just 2.2 percent per year for the Treasury index. That’s in spite of an average income yield of 5.6 percent over the period.⁷

Bond prices fell as interest rates rose, offsetting more than half of the income from bonds over this time frame. The result: Disappointing returns overall.

Considering today’s starting point of less than 2 percent on the 10-Year US Treasury, when interest rates inevitably start to rise again, bond investors may be in store for major disappointment as the bond bubble bursts!

The last time interest rates were this low was 1955, and the total return from US Treasuries fell to just 1.9 percent per year over the next decade. If long-term interest rates merely return to the normally “low” level of say, 4 percent, bond investors are likely to take losses equal to several times the current yield! Long-term bond buyers beware.⁸

Three Proactive Steps to Consider Before the Great American Bond Bubble Bursts

No question, today’s environment of ultra-low yields and a volatile economic climate present unique challenges for fixed income investors. You may want to consider a more active, professional level of oversight for your fixed income portfolio, instead of relying on a passive buy-and-hold approach to bond funds or individual bonds.

Based on how our Banyan Partners custom fixed income portfolios and bond strategies are positioned now, here are a few points to keep in mind.

#1 Duration Matters: In a volatile economic environment featuring uneven economic growth but an ever-present threat of inflation, you should consider reducing the duration of your bond portfolio.

Duration measures the sensitivity of your bond portfolio to changes in interest rates. It’s simply the length of time it takes to get repaid your principal. The shorter your duration, the less sensitive your portfolio should be to a sharp increase in interest rates.

At Banyan, our custom fixed income portfolios have an average duration of less than three years, while still featuring a current yield of more than 6 percent on average.

#2 Diversify Your Holdings: Diversifying beyond traditional US Treasury bonds is more important than ever in today’s low yield environment. You should consider diversifying into corporate bonds or diversified bond funds that offer higher current yields without sacrificing credit quality.

Global bond funds, including emerging markets, also offer broad diversification in regions of the world that in many cases offer better economic growth prospects and higher yields than you can find in the US. While there are certain unique risks involved with international bond investing, there has been a general increase in credit quality among many emerging market issuers. For example, sixty percent of the holdings in the JP Morgan Emerging Market Bond benchmark earn an investment-grade rating today, up from just 20 percent a decade ago.⁹

#3 Go Beyond Bonds: If you’re looking for higher current income and some protection from higher interest rates, your best bet today may be high quality stocks, rather than bonds.

As we pointed out in a previous article, over half of the stocks in the S&P 500 Index offer dividend yields higher than the coupon yield on the 10-year US Treasury.

And in some cases, dividend yields are much higher ... as much as two to three times the yield in bonds.

Unlike bonds, dividend yields can grow larger over time, more than offsetting the corrosive impact of inflation. In fact, average dividend income from S&P 500 stocks has grown 5 percent per year since 1957! So blue-chip stocks may offer a more attractive investment than high quality bonds considering today’s starting point.¹⁰

Bottom line: The uptrend in bonds may still be intact, at least for the immediate future. However, the bond bull market’s days may be numbered since long-term Treasury bonds don’t offer much value from today’s lofty price levels. Fixed income investors could benefit from a more skeptical viewpoint and consider venturing beyond traditional long-term bonds in exchange for  new options for earning income in this environment. Also, taking a more active approach to managing your income portfolio from this point forward is highly advisable.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Bloomberg market data, 12/13/11
² Eaton Vance Monthly Market Monitor, as of 11/30/11
³ Investment Company Institute, 11/29/11
⁴ FMRCo (MARE) as of 12/31/09
⁵ Asset Dedication, November 2010
⁶ Ibid.
⁷ Ibid.
⁸ Wall Street Journal, The Great American Bond Bubble, 8/18/10
⁹ Fidelity Investments Viewpoints, November 3, 2010
¹⁰ Wall Street Journal, The Great American Bond Bubble, 8/18/10