2017 could be a great year for bonds

George W. Karpus, BridgeTower Media Newswires

Many bond market “experts” are again calling for a poor year in the bond market for 2017. If history and data are any guide, these “experts” could yet again be wrong.

At the end of 2015, experts were calling for a rise in interest rates thereby causing bonds to perform poorly. However, the bond market did extremely well during the first half of 2016, making new all-time low yields for longer-term bonds. The second half of 2016 then saw yields climb slightly more than the decline during the first half of the year, wiping out the first half’s gains.

Looking forward to my conclusions on what might occur in 2017 requires a little background about me and my firm. In my nearly 50 years of investment experience, I’ve found that analyzing trends, historical data, and market participants’ behavior provides a more holistic picture than solely using forecasts. Moreover, I’ve found that closed-end funds are a unique security that offers insight into each of these variables.

In watching and actively trading closed-end funds for as long as I have, I consider our investment process one that is based on behavioral science that is consistent and repeatable. Because closed-end funds tend to be heavily utilized by retail investors and retail investors have consistently underperformed, I’ve found that their behavior can be exploited with closed-end funds. What their tendencies then translate into are buy and sell signals through the funds’ discounts and premiums.

This is exactly what we executed in our clients’ portfolios in 2016. The rise in interest rates in the second half of 2015 in advance of the first Federal Reserve tightening caused closed-end fund discounts to be wide, resulting in our clients becoming heavily invested in closed-end bond funds as 2015 came to a close.

By May 2016 though, interest rates had declined and discounts had narrowed, causing us to sell closed-end funds and to significantly decrease the duration (sensitivity to interest rate changes) in our bond portfolios. As a result, we cut our exposure to longer maturity closed-end bond funds by 40%, causing our portfolios to have below benchmark durations by July.

Shortly thereafter, bond investors began to witness one of the worst six-month periods for the bond market in our lifetime. Yields increased substantially, causing a huge drop in bond prices. For example, on June 30, an investor could have purchased a 10-year U.S. Treasury note with a 1% coupon due May 15, 2026, for a price of $101.41 only to see it drop in price to $92.33 on Dec. 19. The 9% drop offset by about .8% income caused the total return for the note to be -8% in less than six months.

In looking at the Barclay’s U.S. Treasury Total Return Index since 1973, investors have only had one six-month calendar quarter ending period where Treasuries performed worse. That was the six months ending on the first quarter of 1980. Thus, the second half of 2016 should go down in history as the second-worst six months for the bond market in the last 43 years.

On a positive note, the following table shows what happens in the six months and one year following negative bond market returns for six months.

Historical data and closed-end fund discounts we are seeing seem to strongly indicate that, contrary to popular opinion, next year could be a very good one for bond investors. In fact, based on history and the carnage in the bond market over the last six months, I feel that there is a 95% probability that 2017 will be a good year for bonds and there is a 60% probability that 2017 will be a great year for bonds.

In terms of my firm’s overall strategy, we are beginning to see buy signals from closed-end bond funds and expect to be increasing our clients’ closed-end fund exposure during the first half of 2017.

Winston Churchill was once quoted as saying: “Those who fail to learn from history are doomed to repeat it.” In my extensive experience, I’ve learned that this applies directly to investing.

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George W. Karpus is Chief Investment Strategist and Chairman of the Board of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585-586-4680).

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