By Michael Johnston for ETF Database
Earlier this year, with the economic recovery showing signs of sustainability and the printing presses in Washington still red hot from an unprecedented injection of liquidity, many well known and respected investors turned bearish on long-term bonds. But there's an old Warren Buffett mantra that calls for opportunistic investors to be greedy when others are fearful. And sure enough, anyone with the foresight to stock up on long-term bonds when everyone under the sun was predicting them to plummet has been handsomely rewarded. While financial headlines have focused on Europe's woes and the numerous hurdles facing global equity markets, long-term bonds are quietly putting together a record year, thriving off a combination of uncertainty and yield starvation.
WHAT WENT WRONG The bear case for long-term bonds was relatively straightforward, and seemingly based on a valid investment thesis. To stave off a depression and stimulate spending, the U.S. Fed slashed interest rates to record lows in recent years. Heading into the new year, anxiety over a surge in inflation was running high after massive injections of capital into the global financial system. It seemed reasonable to predict that CPI would begin to accelerate, forcing the Fed to raise interest rates off record lows. A rally in equity markets -- the S&P 500 gained about 60% during the final 10 months of last year -- gave investors hope that the recovery was off and running and that markets would be able to withstand a rate hike campaign. Because interest rate hikes make existing debt securities less attractive, since investors can get a higher rate from recently issued securities, an inverse relationship often exists between interest rates and bond prices.
Long story short: "Inevitable" interest rate hikes spelled disaster for long-term bonds.Fast forward to August. Many long-term bond ETFs have turned in gains of 20% on the year, including an impressive rally of nearly 10% last week. While uncertainty over the outlook for equity markets has certainly been responsible for part of the rush to fixed income, it clearly hasn't been the only factor. On Monday, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ) climbed 5% on a day when many major equity indexes also finished higher. So what is driving long-term bond ETFs higher? For starters, worries about runaway inflation have largely subsided, only to be replaced by a potentially more devastating concern: deflation. Recent CPI reports have shown that prices may be headed lower -- good news for consumers who see their dollar stretch further, but an unwanted development for equity markets already facing a host of other problems.