Changes for the Bond Market

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Following a huge sell-off in the U.S. bond market that coincided with the sharp rally in cyclical stocks, when the dust settled as of last Friday’s close, the yield on the benchmark 10-year Treasury had risen to 2.29% after briefly tagging the 2.45% level. All manner of dividend stocks tied to defensive sectors have come under severe selling pressure as trigger-happy traders and fund managers pushed their defensive dividend stocks in a wave of selling that resembled the classic Rep. Paul Ryan TV commercial involving pushing an old retiree over a cliff.

U.S. Treasuries took their cue from the economic calendar and it was all downhill for bond prices thereafter. Durable goods orders jumped by 4.8% month over month in October (versus consensus estimates of 1.1%). Existing home sales were stronger, rising to 5.60 million in October from 5.49 million in September (versus consensus expectations of 5.40 million). Topping the headlines was the Atlanta Fed’s GDPNow model forecast, now at 3.6% for Q4 U.S. real gross domestic product (GDP) growth. The U.S. economic recovery looks to be gathering speed from the sluggish pace that prevailed for most of 2016. That said, interest rate markets have priced in a lot more growth and inflation in just three weeks’ time and the Fed’s work of raising interest rates to stem inflation and rising GDP is all but done.

While stronger current U.S. economic data has been supporting Treasury yields, the size and composition of any fiscal stimulus in 2017 remain big unknowns. The Republican-controlled White House and Congress are expected to enact some combination of tax cuts and infrastructure spending next year. The larger the package and the more oriented toward infrastructure it is, the more it should push nominal interest rates higher. The pronounced move in Treasury yields has priced in a good portion of future expectations as to where the move looks overdone, with many blown-out dividend growth stocks that have strong organic growth in earnings and dividend payouts now trading at hugely attractive entry points. It’s as if a Richter-scale-7.5 earthquake rippled through the many income-paying sectors all at once, taking down several terrific growth and income stocks and providing a multi-year opportunity for income investors to pounce on.

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With that said, some very high profile market gurus, namely DoubleLine’s Jeff Gundlach and legendary value hedge fund manager Stanley Druckenmiller, are predicting U.S. GDP to rise to 6.0% by 2019, which would take the 10-year T-Note yield above 3.0% well before that time in anticipation of further Fed tightening. It’s just an incredible turn of events that investors are having to rapidly adjust to in an almost overnight fashion that is very unsettling for those holding tight to their long-dated bond holdings. The only solace is that all bonds mature at par, and that’s the new course for those that failed to sell.

If the chorus of respected Wall Street mavens gets louder on the topic of hotter economic growth going forward, then by all means, these seemingly terrific entry points for the dividend payers are only going to get more terrific. It’s just too early to tell, and because of that, it would be wise to stand aside and see just how high the market wants to take interest rates heading into the year’s end before attempting to bottom-fish too heavily. We’re in the kind of market where more than one shoe could drop for bond investors if the data keeps improving at a better-than-expected pace. Taking partial positions in great dividend stocks is highly recommended, as is dollar-cost averaging as the market permits.

If bonds are the security class of choice, then the ultimate sweet spot on the yield curve are the five- to seven-year maturities. History is strongly on the side of owning maturities in this time frame when rates are on the rise and, as the bond market crushes everything with a longer maturity than seven years, the real hidden opportunity will be for investors to buy into the junk-bond space through closed-end funds that have durations that don’t go out beyond 2022. As the economy strengthens, this debt class gains more balance sheet credibility, and because maturities are reasonably visible, the investment proposition becomes very compelling.

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The chart above is that of the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), which investors interested in this trade should monitor closely. You can read more about this forthcoming scenario in Cash Machine as well as how to position for what should be one of the best buys of 2017 in the making.

In case you missed it, I encourage you to read my e-letter article from last week on the tremendous shift in asset allocations in the market.

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