Record speculative short positions on U.S. Treasuries, combined with increasing foreign government selling of U.S. bonds, create an interesting combination of short-term risk and mid-term opportunity for Canadian income and dividend investors.
The first chart below shows the extent of speculative fervour in U.S. bond futures. The grey line plots the speculative net futures positioning (provided by the Commodity Futures Trading Commission) – contracts betting on a bond-price increase minus those that benefit from a price decline – in the 10-year U.S. Treasury issue. A declining line indicates rising short positions.
The purple line is the 10-year bond yield.
The chart here only goes 12 months, but Bloomberg data show that futures traders are more short on the 10-year bond – betting on higher yields – than at any time in the past 20 years. (Bond yields and prices, of course, move inversely.) The pessimism on the bond price intensified two weeks after the U.S. election, on Nov. 22, as the sharply falling line indicates.
The recent trend of foreign countries selling U.S. government bonds has depressed bond prices and helped keep bond short positions profitable. Bloomberg reports that inflation fears and the potential effects of fiscal spending initiatives on the U.S. federal balance sheet have led to a market where "across the world, foreigners are pulling back from U.S. debt like never before."
Falling bond prices are good for the speculative investors with short positions, but they are bad for the legions of investors in equity-based dividend and income sectors. Falling bond prices mean rising risk-free bond yields, and the less reliable dividend and distribution yields on equities become more unattractive as bond yields rise. In short, higher bond yields lead to lower prices for income-oriented equities.
The U.S. 10-year yield is arguably the most important benchmark in global fixed income. The second chart, using the S&P/TSX REIT index as an example of domestic equity income sectors, shows how U.S. yields have a direct effect on domestic equity markets.
When U.S. yields rose, unit prices for domestic real estate investment trusts have dropped for most of the past 12 months. More recently, REIT prices have been stronger, even with higher yields.
For now, the record number of hedge funds and other speculative investors betting on lower bond prices and higher yields are winning. But the speculative activity is extreme, and when it turns, it will almost certainly turn very quickly as aggressive funds look to unwind their shorts to avoid losses. The most probable path for the bond market is a short-term rise in yields, followed by a rapid decline.
Dividend and income investors will likely see more volatile asset prices than they're used to. Sectors such as REITs that have resisted the negative effects of higher bond yields have limited upside in the short term and a correction is possible as yields continue higher. After that, prices should recover as speculators remove their short positions and yields decline. It would take very good timing, but investors buying dividend stocks close to peak bond yields would generate strong short-term returns until fixed income markets stabilize. For most investors, however, the near-impossibility of timing markets would make this an ill-advised strategy.