The Call Everyone Got Wrong

Making predictions is a hallmark of investment analysis. When you get things right, then it can make your entire career. But when you slip up and make a bad call, it can get you thrown out of the limelight.

But what happens when just about everyone gets something wrong? That's the question that investors have to ask themselves about the bond market, which has defied expectations for years that it would necessarily collapse under the weight of gains from a 30-year bull market.

What came down...
More than 30 years ago, the U.S. faced an economic environment unlike any other in its recent history. In the aftermath of a major oil-price shock and its cascading impact on prices throughout the economy, inflation rose to levels that few today could conceive of. Double-digit inflation rates sapped the purchasing power of the U.S. dollar at an accelerated pace, boosting interest in gold and other hard assets and sending financial assets languishing.

In particular, getting financing became extremely expensive. Even U.S. Treasury bonds carried rates as high as 15%, and riskier debt required even costlier interest rates for bondholders. As inflation expectations remained extremely high, bond investors demanded high rates in order to compensate themselves for the risk they were taking on and to maintain some measure of real returns.

When then-Fed Chair Paul Volcker got inflation under control, interest rates started coming down. Over the years, inflation was held more and more in check, and those bondholders who had been brave enough to jump at 10% to 15% yields on long-term bonds reaped huge rewards.

...never went back up
Fast-forward to recent years, and you can easily see why so many analysts -- myself included -- have argued that we're at the other end of the spectrum. Ten-year Treasuries briefly hit 1.5% not so long ago, and short-term rates have been near zero for years.

Yet investors continue to pile into bonds at a furious rate, despite low yields. The reason? Rates haven't stopped falling, and the consequent price increases on existing bonds have pushed bond-fund share prices upward and created capital gains for those who own individual bonds.

Perhaps more important, the economy has remained steadfast in its resistance to producing accelerating growth. That has directly led to the Federal Reserve's stance to keep interest rates low for a prolonged period, running at least through 2015, and therefore suggests the existence of a "Bernanke put" under the bond market. That idea that the Fed is implicitly standing behind the entire bond market has likely pumped up investor interest, even as the struggling economy starts showing new signs of life.

Whenever the Fed gets out of the quantitative easing business, its bond-market support will go away. That could leave bond investors stuck in long-term investments at poor interest rates that would quickly incur capital losses in a rising-rate environment.

A dangerous game
Having believed that rates would never get anywhere near this low, I'm not going to cry wolf yet again to point to an imminent increase in interest rates. But unless the economy never recovers and we end up in a Japan-like scenario with perpetually low bond yields, investors will eventually need to prepare for the impact of higher rates. In particular:

  • Rate-sensitive stocks would take an initial hit but perhaps gain ground over the long haul. For instance, Annaly Capital (NYS: NLY) and American Capital Agency (NAS: AGNC) would see their existing bond portfolios fall sharply in value. But higher rates could support wider spreads, boosting interest income and eventually leading to better results. Similarly, insurance companies Hartford Financial (NYS: HIG) and Travelers (NYS: TRV) , which have suffered in the current low-rate environment from poor investment returns, would see those returns improve over time -- but their existing portfolios could take a big hit.

  • Companies with big debt burdens that hadn't taken advantage of the current low-rate environment to refinance could be stuck paying more to borrow, hurting income. Conversely, cash-rich companies could benefit greatly from higher rates, with Apple (NAS: AAPL) and other tech stocks with huge cash balances potentially reaping considerable contributions to net income from investment income.

To be clear: These issues could stay dormant for years to come. But just as a slow economy has made the Fed's job in keeping rates down much easier, any acceleration would make it a lot more difficult. So far, selling bonds has been the wrong call, but the stage is set for a dangerous environment somewhere down the road.

Be careful
Before you join the frenzied bond-buying crowd, be sure you understand the risks. You could get stuck with the low rates that bonds offer for a very long time.

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Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Apple and Annaly Capital. Motley Fool newsletter services recommend Apple. 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 Motley Fool has a disclosure policy.

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