Long-term bond yields recently hit an all-time low with the 30-year Treasury at an incredibly low 1.89% yield. The current rally in long-term bonds began in late 2018 after equities saw a roughly 20% correction and inflation fears spiked. Since then, long-term bonds funds like the Vanguard’s (BLV) have risen a bit over 20% in value and many investors and speculators believe that rates will continue to climb due to a potential recession or other risk factors.
While it is generally true that long-term bond funds like BLV are solid defensive assets, I believe the opposite is true today. BLV has 43% exposure to long-term U.S Treasuries and the rest in investment-grade corporate bonds. This gives the fund generally low credit-risk (though it still has some), but with an effective maturity of 24 years, it has very high yield-curve steepening risk and inflation risk.
Quite frankly, I believe BLV is severely mispriced today as it does not appear that its yield is accounting for rising inflation in the U.S. I have explained this risk before in many bond funds, but with long-term yields hitting an all-time low, I believe that the top is now in for bonds and perhaps most fixed-income investments. This is a very contrarian view today, but I also believe that the likely downside in BLV is greater than it is for equities. Let’s go over the evidence.
The Changing Relationship Between Stocks and Bonds
After seeing long-term bonds rocket higher in 2008 while everything else plummeted, many investors have been conditioned to buy long-term bonds whenever they’re even slightly bearish.
It is almost always true that when stocks go down long-term bonds go up and, importantly, when stocks go up long-term bonds go down. This inverse relationship can be seen below from 2007-2016 as you can see below:
However, that negative relationship has problematically been broken over the past few years as both stocks and bonds have rallied to all-time highs together. Note the positive relationship from January 2019 onward.
Of course, they seem to take turns where long-term bonds rally for a few weeks and then stocks rally for a few weeks. As shown below, the month-return correlation between long-term bonds and stocks is negative and at a low while the 3-year correlation between the two is at a positive long-term high:
So, which is it? Are bonds and stocks negatively or positively correlated? From 2010-2015, the three-year rolling relationship was generally negative but it has crept higher over the past few years.
There is actually a logical explanation for this change. The primary risk in long-term bonds is inflation. If inflation rises to 5% and you’re stuck with a 2% fixed-income 20-year bond, you’re effectively losing 3% in purchasing power per year for 20 years. Of course, in reality, all of those losses will occur in a short period. If inflation rises to 5% then long-term bond yields will follow suit and be re-priced. In this scenario of yields rising from 2-5%, the bond would drop 44% (math: 1- 1.02 ^ 20 / 1.05 ^ 20), increasing the bond’s current yield to 5% (matching the new inflation rate).
During recessions, inflation generally falls and the opposite is true, causing a large increase to long-term bond prices which usually concur with equity-market crashes. This inflation-growth relationship is why long-term bonds and equities are usually negatively correlated.
However, things get a bit wacky when quantitative easing occurs. Printing money should promote inflation, but printed money generally goes to Treasury bonds which raises bond prices and pushes yields down.
In late 2018, economic growth expectations dropped (as seen in S&P 500 20% correction) which pushed the U.S inflation rate down from 2.4% to 1% which, through the dynamic explained above, allowed for higher long-term bond prices. However, last year the Federal Reserve acted to stop a recession by printing money and buying repurchase agreements and long-term Treasury bonds.
In fact, the Federal Reserve has increased its ownership of long-term Treasury bonds by about $200B over the past eight months. This $200B inflow has been the driver of long-term bond prices, not economic fundamentals. We know this because inflation, which normally deadly for long-term bonds, has risen considerably during their buying-binge.
Take a look below at BLV’s price trend and notice how it is usually negatively correlated to inflation but has rallied due to Federal Reserve QE purchasing:
This is seen even better on a long-term time horizon:
I know there is a bit going on in these charts, but notice how the relationship between BLV and inflation is negative unless Federal Reserve Treasury purchases are increasing.
This can also be seen in BLV’s dividend yield vs. the inflation rate. As you can see below, there is generally a positive relationship between the two where slides in inflation concur with slides in BLV’s dividend yield (via a boost to BLV’s price). However, the exact opposite has been true since the beginning of last year with inflation heading higher and BLV’s yield lower:
Note, dividend yield below is TTM. BLV’s actually yield-to-maturity today is 2.8%.
Fundamentally speaking, based on Fisher’s Equation, there should always be a one-for-one relationship between bond yields and inflation and the two should never trend in opposite directions unless the market is being influenced/manipulated by outside forces.
“Manipulation” is a bad word, but it is, by mandate, the Federal Reserve’s job to manipulate bond prices. Which, over the past year, has very successfully done so. However, when the Fed’s purchasing of long-term Treasuries ends, long-term bonds will almost certainly crash toward their fair value (i.e a yield where they pay a positive yield after inflation).
The Bottom Line
Today, long-term bond prices have hit an all-time high just the Fed considers pausing its balance sheet expansion (i.e an end to long-term Treasury purchases). Inflation is also at a three-year high and is showing few signs of falling back down while long-term yields are at an all-time low. Indeed, long-term bond prices are incredibly detached from their fundamentals.
Many investors complain that the Federal Reserve’s QE program has manipulated stock prices/valuations. While this is likely true, it pales in comparison to the Federal Reserves’ manipulation of long-term bond prices. This “manipulation” may not be nefarious as it allows the Treasury to more easily run a Trillion-dollar deficit, but it is certainly nefarious if you’re a long-term bond investor. This is because it causes investors to wrongly think that bond prices are rising due to fundamentals when in fact it is due to aggressive open-market-operations.
Again, inflation and equities are rising, the two strongest historically bearish signals for long-term bonds. Once the purchase program ends, it is likely that BLV will fall 15% as its yield rises from 2.8% to 3.8% to reflect its historically normal 1.2% post-inflation return.
Quite frankly, I believe that the inflationary price impacts due to supply-chain and food shortages due to the Coronavirus (and generally low production growth) could bring inflation to 5% as has happened to China over the past year.
China’s inflation is 5.4% today and was 1.5% a year ago originally due to food shortages. The U.S is boosting food exports to China which will bring some of China’s inflation to the U.S (particularly considering the Yuan has been held up).
Of course, it may take one to three years for this to occur, but if it does, it is likely that BLV’s YTM will rise from 2.8% to around 6.2% which bond math tells us is likely to result in BLV falling 65%.
I believe that BLV and other long-term fixed-income bond ETFs are “sells”. Since the spread between its dividend and inflation has reached such an extreme and the Fed’s purchasing program is about to be wound down, I doubt the current rally in long-term bonds will last.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in BLV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.