The recent bond market selloff is a buy-the-dip moment for investors willing to gamble on longer-dated issues.
Higher yields are spooking bond investors. Your best bet may be to lean in, according to the co-manager of one of the market’s largest bond funds.
The Iran war and stubborn inflation have sent bond yields shooting up in the past few weeks, hurting bond investments, since bond prices move in the opposite direction of yields. On Wednesday, the yield on 10-year Treasury notes stood at 4.49%, up from less than 4% at the start of the conflict. The 30-year Treasury bond yield is just below 5%.
For bond investors, the natural reaction is to move up the yield curve, targeting shorter-dated bonds, or even money-market funds, since these offer yields that are almost as generous as longer-dated bonds and tend to be less price sensitive to interest-rate moves. Leading money-market funds yield about 3.7%, according to Crane Data, which tracks the sector.
Investors need to resist this temptation, and stay long rather than go short, says David Hoag, portfolio co-manager of Capital Group’s $101 billion Bond Fund of America. It’s the largest actively managed fund in Morningstar’s intermediate core bond category, composed of plain-vanilla bond funds designed to be core holdings in investors’ portfolios. Its 10-year average annual return of 2.1% puts it in the top 16% of the category.
Bond Fund of America’s portfolio is more or less split in thirds among Treasuries, investment-grade corporate bonds, and securitized bonds such as mortgage-backed securities. But while many investors are fleeing long-term bonds, Hoag notes the fund’s duration, a measure of bond portfolios’ average maturity, is around 6.1 years—compared with 5.6 years for the average fund in its category—making its returns even more sensitive to interest-rate changes.
Hoag, who describes himself as a “gentle contrarian,” says the selloff is a buy-the-dip moment for bond investors willing to gamble on longer-dated bonds. “There is an opportunity coming here,” he says. “I can’t name you the day, but I think there’s an opportunity when people are moving out. It means opportunities are arising.”
Hoag concedes the recent spike in bond yields is tied to inflation worries. But he argues investors need to distinguish between inflation’s two flavors: “virtuous” inflation, when economic growth makes consumers richer, driving up prices, and “vicious” inflation, when a supply shock drives up prices for goods like oil, acting like a tax on consumers, especially lower-income ones who spend a bigger share of their budgets on day-to-day goods.
So far, despite the war in Iran, the market is mostly betting on virtuous inflation, he argues. The stock market remains near record highs and corporate bond spreads are at historic lows.
Another key indicator also suggests the problems are temporary. The break-even yield on five-year Treasury inflation-protected securities currently stands at 2.5%. This number, the difference between Treasury and real TIPS yields, indicates the market’s best guess for future inflation. The fact that the current five-year reading stands well below today’s inflation rate of 3.8% indicates most investors actually see inflation cooling over the next several years.
Of course, there are dangers. The longer the war in Iran drags on, the greater the toll of high gasoline prices on global consumers. That would mean more “vicious” inflation, further pushing up bond yields.
But, Hoag adds, bond investors have an insurance policy against this worst-case scenario. Currently, futures markets suggest the Federal Reserve, in a bid to keep inflation under control, is likely to raise interest rates once this year. If the economy starts to slow significantly, rate cuts could quickly be back on the table.
While the Fed controls only short-term interest rates, a rate cut would likely pull rates down all along the yield curve, giving prices for longer-dated bonds a tailwind. Meanwhile, investors who shifted money into shorter-dated bonds would see smaller price gains, and investors who fled to money-market funds would see no gains at all—merely lower yields.
In that scenario, investors who moved to cash today could end up shooting themselves in the foot. “You will crystallize your losses,” he says.
Write to Ian Salisbury at ian.salisbury@barrons.com