Long live thebond market bull .
It started running in 1980, when a series of interest rate
increases by the Federal Reserve finally broke the back
ofinflation , and it galloped onward for more than three decades.
Yet the bond market bull died a quiet death on July 25, 2012,
when theyield on the 10-yearTreasury note fell to just 1.43%.
Though 10-year Treasurys may see their yields drift lower once
again if the U.S.economy slows down from its current pace, it's
hard to see yields ever again falling to the levels we saw last
July. Back then, a looming government shutdown threatened to
imperil the U.S. economy, spooking the bond markets, though no
such shutdown is likely to happen in the future. Congress woke up
and realized the foolishness of that possibility.
More than likely, that steady uptrend you see in the chart
abovewill continue moving in that direction. Whether in a slow or
rapid fashion, a firming U.S. economy will set the stage for
higher rates down the road asbondholders demand higher payouts
tooffset the risk that increasingly vigorous economic activity
may lead to higher inflation.
For investors, the key question is where bond yields will be
when the U.S. economy is back in decent shape. And where bond
yields land will have a direct impact onstocks as well, most
notably dividend-paying stocks.
Tossing Out The Outliers
Just as the past few years have been quite anomalous in the
context of long-term interest-rate trends, so were the 1970s.
Many still recall the double-digit inflation and interest rates
that decade, which were due to a confluence offactors that is
unlikely to repeat. As the 1970s and the past few years should be
seen as outliers interms of historical interest rates, we should
instead look at the era from 1980 to 2010 to see how interest
rate trends played out.
The 1980s were still affected by the bad memories of the
1970s, and the yield on the 10-year Treasury often exceeded 8%.
By the early 1990s, inflation expectations started to dim and
throughout that decade, we saw a steady drop in yields. Broadly
speaking, we can look to the average yield on the 10-year
Treasury over the past two decades and arrive at a figure just
north of 4%. That's roughly the interest rates seen from around
1998 to around 2008.
What's so special about a 4% interest rate? That's roughly the
yield that gently brakes an economy from becoming overheated.
(Indeed, a move above 5% in late 2007 gets some of the blame for
an eventual sharp slowing in the economy in 2008.) Yet it's not
so high a yield that chokes off economic growth. In effect, in a
moderately growing U.S. economy -- let's say in the range of 2.5%
to 3%GDP growth -- bondholders andthe Fed would likely work in
tandem to keep rates in the 4% range.
The good news: A 4% yield on the 10-year U.S. Treasurys has
historically coincided with healthystock markets. That yield
simply isn't high enough to pull vast sums out of the stock
market and into the bond market, as was the case in the
Still, that's not all good news for dividend-paying stocks.
After all, the average yield on stocks in the S&P 500 is
currently around 2%. As bond yields rise, stocks with that kind
of yield will keep rotating out of favor until theyoffer up
yields (andcapital appreciation ) that promises a better
Let's look at the major drugmakers as an example. As I noted
last week, drug stocks traded for a number of years withdividend
yields in excess of 5% to compensate for a lack of share price
growth. Yet over the pastyear , these stocks have rallied higher,
in part due to a firming broader market and investors' search for
, for example, has rallied nearly 50% since October 2011, and its
yield has fallen from above 5% to a recent 3.6%.
When rates start to rise, will investors start to flee stocks
like Merck? If that happens, a falling share price will boost the
yield, creating a fresh entry point for stocks like this.
As we've noted in other recent columns, it's really dividend
growth that counts. Merck's dividend was frozen at $1.52 a share
for six straight years before a one-time 10.5% increase last
year, to $1.68. The 2013 dividend was boosted another 2%, which
is likely a sign of things to come. As you seek out dividend
plays, look for companies that are capable of generating robust
dividend growth such as
Intel (Nasdaq: INTC)
JPMorgan Chase (
Risks to Consider:
It's unclear how the bond market will respond to the eventual
end of the Fed's quantitative easing programs, especially as all
of theliquidity that was pumped into the economy gets reabsorbed.
So a chaotic bond market response cannot be ruled out.
Action to Take -->
More than likely, the remaining global economic headwinds will
keep our bond market from running into trouble. Instead, look for
an orderly and gradual rise in interest rates that leads
investors to re-assess the appeal of various income-producing
stocks. There's no need to rush out and make radical moves now,
but get ready to establish a long-term plan that accounts for
changing interest rate trends.
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