After 32 Years this Bull is Officially Dead

Dear Money Morning readers:

I'm announcing that the 32-year bull market in bonds is officially dead. 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.

I'll show you how.

Interest rates will gradually rise this year, but watch out next year. Here's what we see right now.

Ten-year Treasury bond yields are up from 1.76% to 2.53%. On that basis, by the end of the year, if market behavior repeats itself, 10-year Treasuries could be yielding 3.30%. That has important implications for the U.S. 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.

Don't Fear the Yield Curve

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.

Safe for 2013

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 companies like Annaly Capital Management (NYSE:NLY) and American Capital Agency Corp. (Nasdaq:AGNC) 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, the rise in long-term rates will 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.

To play the likely changes, consider buying out of the money puts in the mortgage REITs or in one of the big housing companies such as Pulte Home (NYSE:PHM), which is trading at more than double its price of a year ago and at more than 3 times book value.

If you don't like derivatives, look at buying ProShares UltraShort 20+ year Treasury ETF (TBT) which takes a doubled short position in long-term Treasury bond futures.

Because of the difficulties with hedging, UltraShort ETFs don't always perform as well as they should (see my recent article: "Ultra" ETF Investing: The Newest Portfolio Killer), based on the performance of the underlying index. Still, you would have made a 19% profit holding TBT since January 1, and based on the forecast outlined here you ought to do about as well again in the second half of the year.

If you don't like the risks of Ultras, you can get much the same effect by buying out-of-the-money January 2015 puts on TLT, the long Treasury bond future.

Martin also looks at REIT opportunities in the Midwest here.