Bond yields are on the rise, just as Warren Buffett predicted. It potentially spells more trouble ahead for the stock market.
I've been watching the market for U.S. government bonds with a wary eye for a while now, and I'm certainly not the only one. In his annual letter to Berkshire Hathaway shareholders earlier this year, Warren Buffett said "the U.S. Treasury bond bubble of late 2008 may be regarded as almost equally extraordinary" as the Internet bubble of the late 1990s.
Why would he make such a bold statement? A quick look at bonds over the past 40 or so years shows that the yield on 10-year U.S. Treasuries peaked in the mid-teens back in the early 1980s and has steadily fallen since then, to get us to the 3.9% yield they are currently experiencing. For comparison, 10-year UK gilts currently yield a very similar 3.8%.
Just as stock market investors get burned when they pay too high a price for a share in relation to its profits, bondholders put themselves at risk when they accept a yield that's too low -- particularly when the issuing government is printing money like it's a new video game.
For a while, I was regarding the bond market as a bomb that was about to go off in a contained area -- similar to the way people were talking about subprime mortgages in the early days of the credit crisis. More recently, it's been hitting me like a Chuck Norris roundhouse kick that my previous viewpoint was just silly.
The Credit Market Problem
If the bond bubble meets an unfriendly needle, investors will push down the prices of US Treasuries and UK Gilts. When those prices fall, the yields will rise. When the yields on the secondary market rise, new issues will have to be priced with higher yields to get them sold. Higher-yielding new issues could start a negative feedback loop that will spook bond investors further.
I'm no bond expert, but I do know from listening to bond-smart folks that, unlike Las Vegas, what happens in the Treasury and Gilt markets doesn't always stay in the Treasury and Gilt markets.
Rising Treasury and Gilt yields will feed into other parts of the bond market and push up yields on things like corporate debt and mortgages. Jumping mortgage rates would put a major damper on any nascent stabilisation in the housing market, just as higher corporate rates would make things even more difficult for debt-laden companies like Yell Group (LSE: YELL) and British Airways (LSE: BAY).
And of course it would get much more difficult for the US and UK governments to continue trying to hoist the economy out of the muck if they find themselves suddenly having to finance massive deficits with increasingly pricey debt.
The Stock Market Problem
Unfortunately, the stock market probably won't get to whistle past the graveyard if the bond market starts tumbling. As I noted above, there are problems aplenty created by a struggling bond market, and these will likely impact everything from general economic conditions to corporate profits to stock market sentiment.
All in all, it doesn't quite sound like a recipe for stock market success. Remember that in the 1960s and '70s, bond yields rose rapidly -- starting at a level similar to what we see today -- and, at the same time, the stock market largely stagnated. With an already fragile economy, it'd be tough to expect shares to hold up much better this time around.
In fact, over the past few days, we've seen exactly how bond market events can impact the stock market. The market's loss on one day last week was largely attributed to a weaker-than-expected demand for an auction of 10-year Treasury notes, while the rebound the day after was driven by strong demand during the sale of 30-year Treasuries. Want to guess what the impact might be if we had an extended slump in the bond market?
A Prepared Portfolio
All that said, I'm not draining my portfolio of shares and running for the hills. Instead, I'm starting to eye shares that will weather a bond-market storm well.
What do these potential survivors look like? Well, I'd include the traditional "defensive" stocks such as GlaxoSmithKline (LSE: GSK) and Unilever (LSE: ULVR) in the group. Quality companies that have little or no reliance on debt -- companies like Invensys (LSE: ISYS) -- would also be a good pick.
And since rising bond yields and inflation usually party together, exposure to commodities could help stabilize your portfolio as well. I'm not much of a fan of gold, but ever-useful commodities like oil and fertilizer have piqued my interest. There are a heck of a lot of shares that can get you exposure to commodities, but big boys like Royal Dutch Shell (LSE: RDSB) and BP (LSE: BP) are easy ways to hitch your buggy to oil, while over in the US, Mosaic (MOS) is one of the key companies in the fertilizer market.
There's no reason that these "bond disaster preparedness" shares have to take over your entire portfolio, but they can sure be a nice defensive complement to riskier or more pro-cyclical picks.
Is the best offense a good defence? We may soon find out.
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson. Of the companies mentioned in this article, Bruce Jackson has an interest in GlaxoSmithKline.
