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Dead at 32, the US Bond Bull Market

The end of the US bond bull market will see rising interest rates hurt mortgage REITs...

I AM announcing that the 32-year bull market in bonds is officially dead, writes Martin Hutchinson at Money Morning.
Be prepared for the consequences from rising interest rates in 2014. They could be catastrophic for bond market investors.
Higher bond rates look enticing, like they'll provide you with more income. But as interest rates move up, the value of bonds goes down. It's an inverse relationship. The value of your fixed-income portfolio could be devastated if rates rise rapidly beginning next year. Start protecting your portfolio today.
Interest rates will gradually rise this year, but watch out next year. Here's what we see right now.
Falling since 1981, 10-year US Treasury bond yields are now up from 1.76% to 2.53%. On that basis, by the end of 2013, if market behavior repeats itself, 10-year Treasuries could be yielding 3.30%. That has important implications for the US economy, for the Fed and for investors in every sector, in almost every country.
But this bond market bonanza's end isn't a shocking development. Knowing now that interest rates aren't coming back down will give you an advantage in protecting your portfolio.
Some kind of turn in interest rates was inevitable and is healthy. The 2012 year-end yield of 1.76% was the lowest year-end yield for the 10-year Treasury since records began in 1962. It also gave investors approximately a zero real yield after inflation, which translated into a negative real yield for investors paying taxes, since interest payments are taxable and the inflationary erosion of the principal's value is not tax-deductible.
It is however remarkable that interest rates turned only after the Fed had begun buying $85 billion of bonds per month, split roughly equally between Treasuries and housing agency bonds.
It also coincided with the first significant action on the Federal deficit, with the "fiscal cliff" at year-end increasing top-bracket taxes and employees' Social Security payments, and the March "sequester" making modest cuts in spending.
The combined effect of these two acts was to being the federal deficit down from just over $1 trillion in 2011-12 to around $650 billion in 2012-13, which doesn't solve the deficit/debt problem but at least makes a dent in it.
In the second half of 2013, the forces holding down interest rates will be weaker. The Fed's Ben Bernanke has more or less committed to beginning to reduce the pace of bond purchases in the latter part of the year, while there's certainly not going to be any more useful action on taxes or spending.
Judging by the pork-bloated agriculture bill recently passed by the House, spending could even increase again in the new fiscal year, which begins October 1.
Since the economic forces pushing up interest rates were strong enough to overcome the Fed's $85 billion a month of bond purchases plus a sudden outbreak of fiscal sanity by the politicians, it's likely they'll be even stronger when those two special factors are reduced or absent.
So my simplistic projection of 3.3% for the 10-year Treasury yield on December 31 may, if anything, be on the low side.
Now, it's unlikely that the rise in interest rates will cause a crisis before December, although a crisis is certainly very possible next year. At 3.3% we're below the average of interest rates in the second half of 2009 and the first half of 2010, so banks and financial market participants should adjust to it fairly easily.
The economy as a whole should also adapt fairly easily, although the recent exceptional strength in the housing sector may very well diminish as mortgage rates rise and housing affordability falls.
Where to beware? The biggest strains will come in the mortgage REIT sector, where some companies depend crucially on a high degree of leverage and a substantial gap between short-term and long-term rates to sustain their very high dividend yields.
In the scenario I envisage, the gap between short-term and long-term interest rates will even increase, because the Fed isn't likely to raise short-term rates. That will increase the mortgage REITs' operating profits. However, a rise in long-term rates would reduce the value of their mortgage portfolios, eating away at their capital and possibly even making them insolvent when their balance sheets are "marked to market" at year-end.

Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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