“By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”

- Ben Graham, ‘The Intelligent Investor’.

There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.

Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:

David Fuller's view

Here is Tim Price's letter.

Bond investors are not behaving irrationally.  If they are old enough to have bought bonds over thirty years ago, shortly after former Federal Reserve Chairman Paul Volcker’s monetary squeeze to tame inflation was ending, they have participated in one of the greatest bull markets of a lifetime (50-year total return & weekly 10-Yr). 

Moreover, they have the Fed on their side, thanks to quantitative easing (QE), which Ben Bernanke introduced in 2009, giving the bond bull market an additional run.  Billions of dollars worth of bonds have been purchased by the Fed every month, but not for much longer.  QE is being wound down and should be finished before the end of October. 

That should certainly give bond investors pause for thought, but they are not losing money at the moment as you can see from the total return charts above.  Moreover, bond investors will know all about the extreme stock market bear trends in 2000 and worse still in 2008, which may influence their perceptions of risk, even though stock markets have certainly outperformed over the last year and a half and the global economy is slowly recovering from the credit crisis recession.

I hope bond investors will add the total return chart above to their Favourites section and keep a close eye on it.  To paraphrase the adage: the bigger the bull market, the harder the fall.  The next obvious spike in US Treasury yields will be a serious warning.  This is not a matter of if, but of when that occurs.