Bond investors should brace themselves for a significant reversal.
While corporate fixed-income has done well these past few months, the gold market suggests that may be coming to an end soon. The problem is that a rallying bond market and surging gold prices would seem to be incompatible, according to new research.
"Fixed-income investors should be prepared for a reversal in the high level of bond prices," states a recent report from financial research company HCWE & Co.
Markets at Odds
Indeed, the bond market has done exceptionally well lately. For instance, the Fidelity Corporate Bond (FCOR - Get Report) ETF, which holds a basket of corporate fixed-income securities, shows total returns of 14.8% so far this year, according to Morningstar.
Such a rally is consistent with lower inflation.
That bounce in bullion prices is consistent with rising inflation.
There you have the puzzle. Both can't be correct.
"[The] unprecedented explosion in bond prices around the world is an anomaly, at odds with the big price boost in gold," the report says. "There is no escape from the conclusion that rising bond yields and a rising gold price cannot co-exist for long."
Or put bluntly, this state of affairs, meaning the bond rally, will soon be over, or gold rally will reverse.
An Unfree Bond Market
The HCWE research points to the fact that the gold market is more likely to be correct.
The bond market has been subject to large-scale interference lately, notably from the Federal Reserve. That means we can't necessarily take what we see from that market on face value.
On the other hand, the Fed isn't going out and buying gold, disrupting the bullion market. "The gold price is dominated by market forces," the report notes.
Given that the gold market is more likely to be correct than the bond market, then we can expect inflation to rise in short order.
When that happens, the report says the drop in bond prices could be "dramatic."
Lessons From History
For the relationship between rising inflation and the bond market look no further than the classic example from the 1970s. Borrowing costs for triple-A rated corporations almost doubled in the decade through March 1981, according to data from the St. Louis Federal Reserve. That coincided with rising prices of consumer goods which took the annual inflation rate from 3.3% in 1971 to 12.5% in 1980, according to government data collated by TheBalance.
The point here is not that borrowing costs are going to double anytime soon. But rather that when inflation increases, then we can expect borrowing costs to rise.
When interest rates do rise, then the bond market will fall. That is pretty much as certain as anything gets in investing. And the longer-dated bonds will see their prices get hit harder than will shorter dated ones.
That means the savvy investor who sees inflation taking hold should consider shifting at least some fixed income holdings from longer-dated holdings to shorter-dated ones.
For example, investors might consider the Vanguard Short-Term Corporate Bond (VCSH - Get Report) ETF, which holds a basket of shorter-dated bonds. The average bond maturity is three years and the average rating is A, well inside the investment grade grouping.
There are many other similar funds by other ETF providers, which can do the job of helping lower bond market risks.
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