Get Ready for (Somewhat) Higher Rates

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For years, professional investors have been calling for a reversal of the long bull market in bonds. For years, they've been absolutely, positively wrong.

Now, though, after hitting multidecade low yields, the bond market has made a big turnaround, and rates on long-term bonds have moved up dramatically in just a short time. Is this just another head-fake that will eventually reverse itself and allow rates to go even lower, or is the long-awaited bear market in bonds finally beginning?

What we've seen
At the end of July, rates on government bonds dove to new lows, with the 10-year Treasury falling to just 1.4%. At that rate, the 10-year's yield represented less than 70% of the dividend yield on the S&P 500 and barely half the yield of the Dow Jones Industrials (INDEX: ^DJI  ) . Similarly, the 30-year Treasury dropped below 2.5%.

But in just three short weeks, rates have made a major reversal. The 10-year's yield has jumped all the way to 1.84% as of yesterday, while the 30-year now yields nearly 3%. Such wide swings are far from commonplace, and especially given how many investors have flocked to bonds for safety regardless of price or yield, it's essential to understand the risk involved in investing in bonds right now.

Bond ETFs can give you a read on the true impact of rising yields on bond prices. The iShares Barclays 20+ Year Treasury ETF has lost 8.5% of its value during those three weeks. The ProShares Ultra 20+ Year Treasury ETF, a leveraged ETF on long-term Treasuries, has dropped more than 16% in that time period. Even shorter-term bond funds have made some dramatic moves downward.

Immune from the move
Interestingly, though, the move thus far has largely been restricted to the Treasury market. Corporate bonds, both investment grade and high-yield, have seen some modest declines, but nothing like what the Treasury market has had to endure. The same holds for municipal bonds, which have seen huge inflows as investors become increasingly interested in protecting themselves from the adverse impact of taxes on their interest income.

If you take a longer-term view, though, none of this is particularly surprising. That's because Treasury bonds had stronger gains than most other types of bonds during their bull market run, so it only makes sense that the higher they went, the harder they'd fall.

When you look at relative value, some types of bonds stand out. Munis, for example, still yield more than Treasuries of comparable maturities in most cases, despite their tax advantages. But corporate bond spreads have narrowed to their tightest levels all year, prompting Kinder Morgan Energy Partners (NYSE: KMP  ) , Leggett & Platt (NYSE: LEG  ) , and PepsiCo (NYSE: PEP  ) to take advantage of the low rates by issuing bonds in the past week. Even bond-rating agency Moody's (NYSE: MCO  ) stepped off the sidelines and sold $500 million of its own debt earlier this week.

What's next?
Because the Federal Reserve uses the Treasury bond market as a major vehicle for policy change, especially since the advent of quantitative easing and Operation Twist, Treasuries operate in their own market niche. The key, though, will be to look at what rates in other parts of the bond market do. If they start following suit and heading higher, then it's likely that we will have seen at least a short-term bottom in interest rates.

That in turn should prompt you to start taking action to take advantage of low interest rates while they last. If you've been waiting to refinance a mortgage or other debt, for instance, you may not want to wait any longer.

Finally, low rates have been partially responsible for pushing the stock market up, as income investors have had few viable bond-market alternatives. It'll take a while for bond rates rise to attractive levels again, but if they do, then it could create an obstacle for stocks to move higher.

Even if rising bond rates create headwinds for stocks, the best companies can get you moving in the right direction. We've found three hidden treasures, and we're naming names in our latest special report: "3 Middle-Class Millionaire-Maker Stocks." It's free and waiting for you.

Fool contributor Dan Caplinger has been ready for higher rates for far too long. He doesn't own shares of the companies mentioned in this article, although he does own municipal and corporate bonds. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of PepsiCo. Motley Fool newsletter services have recommended buying shares of PepsiCo and Moody's. Motley Fool newsletter services have also recommended creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will get you higher.

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  • Report this Comment On August 20, 2012, at 10:32 PM, MHedgeFundTrader wrote:

    The Treasury bond market has just suffered one of the most horrific selloffs in recent memory, taking the yield on ten year paper up from 1.38% to an eye popping 1.83% in weeks, a three month high.

    Yields have just risen by an amazing 38%. This has dragged the principal Treasury bond ETF (TLT) down from $132 to $120. Those who were pining to get into this safe haven at a better entry point now have their chance.

    Rumors for the plunge have been as numerous as bikinis on an Italian beach. Some have pointed to a suspected unwind of China’s massive $1 trillion in Treasury bond holdings. Others point to the incredibly thin summer market trading conditions. Add to that a relentlessly heavy new issue calendar by the government. After all, they have a $1.4 trillion budget deficit to finance this year. That works out to $4 billion a day.

    Long term strategists point to more fundamental reasons. The spread between the ten year yield and the S&P 500 dividend yield is the narrowest in history. Even after the recent slump, equity yields still beat bonds by 20 basis points. This has never happened before. The smarter money began shifting money out of bonds into stocks months ago.

    However, I think that an excellent trading opportunity is setting up here for the brave and the nimble. There is a method to my madness. Here are my reasons:

    *US corporate earnings are slowing at a dramatic pace. Some 40% of those reporting in Q2 delivered revenues misses. They made up the bottom line by firing more people. This is the worst performance since early 2008. Remember how equity ownership worked out after that?

    *The high price of oil is now starting to become a problem and will inflict its own deflationary effects. If we maintain the 24% price hike we have seen in recent months, that will start to present a serious drag on the economy.

    *Fiscal Cliff? Has anyone heard about the fiscal cliff? This 4% drag on GDP growth, another name for a recession, is looming large.

    *Don’t forget that the rest of the world economy is going to hell in a hand basket. The China slowdown continues unabated, and a hard landing is still on the table. Europe is in the toilet. Japan’s growth is on life support.

    *The Chinese aren’t selling. They told me so. They are merely reallocating a larger portion of their monthly cash flow to Europe where yields are a multiple higher. They are doing this because I told them to. This helps support the Euro. Keeping the currency of its largest trading partner strong to preserve exports is in its best interest.

    *QE3? Remember QE3? Even if the Federal Reserve doesn’t implement this expansionary monetary policy, Europe will. And the Fed will probably join in 2013 when we head into the next recession.

    *Paul Ryan for VP? If elected, his death wish for the Federal Reserve will send asset prices everywhere plummeting, including stocks and bonds. Since Romney’s fumbled announcement, Treasury bond yields have soared by 25 basis points.

    There are many ways to play this game. Just pick your poison. The obvious pick here is to buy the (TLT) just over the 200 day moving average at $119. You could buy an October $120-$125 (TLT) call spread in the options market for a quick bounce. If you really want to get clever, you can sell short the $110-$115 call spread, which has a breakeven in terms of the ten year Treasury yield of 2.10%.

    The safe haven trade is not gone for good. It’s just enjoying a brief summer vacation.

    The Mad Hedge Fund Trader

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