Bond Prices Set To Fall - Dreaded Rising Interest Rates Is Nigh Upon Us

Posted by Brian Fletcher on 14/07/2019 0 Comments

Long-term interest rates are setting up for a significant rise, and the implications could be staggering.

Investors have grown complacent with lower rates, and how quickly they forget the effect that escalating rates have to the underlying value of their bonds and total return.

An intermediate term opportunity to short bonds is setting up nicely.

The pullback in the value of bonds caught a few investors' attention as they viewed their monthly brokerage statements over the last few years, but the quick rebound in bond prices since the low in late 2018 has brought complacency back into the equation. This complacency won't last long, though, as bond prices, as expressed in the price of the iShares 20+ Year Treasury Bond ETF (TLT), formed a solid impulsive move down off their July 2016 high.

For those unfamiliar, what this means is when an impulsive chart pattern occurs, it's never a standalone move. In other words, it's either the beginning of something, or the end of something. In this case, since this occurred off the high and counter to what has been a long-term trend of lower interest rates, it is the beginning of something.

Put differently, the move up off the November 2018 low in TLT is corrective against the larger move down that preceded it, which strongly suggests that upon completion of this current rise in bond values, there will be a move down that is minimally the same size as the initial move down, or in a more dire scenario for bond holders, the move down will form a much larger impulsive move to the downside. Putting this into perspective, the move down in shares of TLT, once it tops out in this present corrective wave structure, will minimally take share prices down to the $106-$95 region, or a whopping 32% drop. If a much larger impulsive move down occurs, then TLT could drop to as low as $62, the 2.382 Fibonacci extension, for an even more whopping 55% drop. See the TLT Weekly Chart below.

TLT Weekly Chart

TLT Weekly Chart

If this scenario doesn't make one consider the potential implications, then it really should.

Firstly, this will dramatically effect housing sales and prices. After all, home values are tied directly to interest rates and mortgage payments investors can afford. Other than to make mention, I won't opine on the ongoing interest rate arbitrage play that has been occurring for some years now, other than to say that those utilizing short-term credit to margin holdings in longer dated bonds will soon see the deterioration in the value of their portfolios eat up whatever little margin equity is required to play this game.

Classic of those who do this are banks, and in particular small community banks. Over the years, they have accumulated longer dated portfolios of collateralized mortgage and corporate bonds with little or no hedge against a decrease in the value of these portfolios, or in the cost of funds borrowed to fund such portfolios, where said borrowings are tied to short-term rates. Long term, funding long-term bonds with short-term debt is not exactly a good match, and sooner or later it will come home to roost in a very negative fashion.

In addition, and likely what is one of the most tragic consequences of what I'm describing is how unsuspecting individual investors have been programmed to believe that bonds are a safe haven to that of equities. Over time they have been gradually lured into longer dated portfolios of bonds in order to replace badly needed or wanted income, and of course, the longer dated bonds will take bigger hits in their values as interest rates rise, leaving these investors with portfolios of bonds that have a considerably less value with little choice but to ride them to maturity while earning dismal annual returns.

Collateralized mortgage bonds will see average maturity lengths increase, where investors have expectations of returns of principal to cycle through into higher interest bearing instruments, yet a dramatic slowdown in principal pay downs will occur when homeowners decide it's better to sit tight with a comfortable payment on an existing low mortgage rate versus selling their home in favor of cycling into a new home with a higher mortgage rate.

All in all, the implications of rising rates can be quite profound, and I've only scratched the surface.

There are those who will respond to this article and claim that rates are bound to stay lower on long dated treasuries since the Fed is committed to keeping interest rates lower, and even reduce them to continue to sustain favorable and controlled growth of inflation. Allow me to dispel this rather unwarranted assumption. Bond price can, and most likely will, drop in value as interest rates required to attract investor capital increase over the next 2 years, and ultimately one has little to do with the other in a public marketplace.

There are of course ways to contend with a declining bond value scenario for investors. The most obvious is to simply exit bond exposure before they drop in value. Another is to buy shares of an ETF that is inverse the value of bonds - i.e., the ProShares UltraShort 20+ Year Treasury ETF (TBT), a 2x leveraged short bonds ETF as a way to hedge the value of a bond portfolio and preserve total return.

From a pure trader or investor perspective, buying shares of TBT for the large move down can be an attractive intermediate investment opportunity.

While we expect bond values to drop, in the short term, we are still expecting somewhat higher prices. See the TLT Daily and 4 Hour Charts below, which show that after a small pullback into the $130 region, we are still expecting a move in TLT shares up to the $136-$139 region.

TLT Daily Chart

TLT Daily Chart

TLT 4 Hour Chart

TLT 4 Hour Chart

In conclusion, after a little more upside, we are expecting a reasonably large to very large drop in the value of bond prices. The implications of a rise in interest rates can vary from reasonable high to very high levels of discomfort for many investors, and the difference between which will depend on how deep bonds extend once they start down. There will also be macroeconomic implications that can effect housing prices and much more. For those seeking to hedge bond portfolios and/or looking to capitalize on the move down, there are some attractive investment approaches, including simply buying shares of inverse ETFs.

For those who imagine that their retirement or pre-retirement dollars are impervious to a drop in value because they have bond exposure, now is the time to consider the implications of how a drop in bond prices will effect your hard earned savings, and to take action by exiting this exposure in favor of cash instruments like money market accounts. For those chasing yield, now is the time to consider a total return approach versus a current yield that fails to consider the consequence of bonds falling in value.

An extremely attractive investment opportunity will be setting up later this year for those opportunists among us who are seeking a wonderful investment opportunity in the form of shorting longer term bonds.

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