Goldman Sachs strategists have issued a big warning to clients hiding out in bond funds: You’re about to lose your shirt.
The reason: interest rates began rising this week, and if they return to the historical average yield of 3 per cent, prices for long-term bonds will plummet. (By their very nature, fixed income prices must fall if rates rise.)
“A reversion of risk premiums to historical averages of 6% nominal rates (3% real rates and 3% inflation) would suggest estimated losses in portfolios with bond durations of 5 years of 25% or more,” equity strategist Robert D. Boroujerdi said in a note.
The yield on the 10-year Treasury hit almost 2 per cent this week–an 8-month high–after minutes from the Federal Reserve’s last meeting showed several members believe the central bank’s quantitative easing should end this year. (Read More: End of Stimulus? What’s Behind the Fed’s Surprise Statement)
That’s one giant bond buyer leaving the market.
Instead of bonds, Goldman suggests investors look to equities for income. That’s because companies have plenty of cash to pay out on their books, mutual fund flows are set to pick up for stocks and equity valuations relative to bonds are very attractive. They list a number of “income-through-equity” plays.
“Companies that return cash to shareholders in the form of dividends or accretive buybacks should outperform, in our view,” wrote the Goldman team.
Specifically, Bristol-Myers, Lorillard, Verizon, and Duke Energy are highlighted by Goldman because they have ample cash flow to comfortably pay their existing debt and then increase their dividend. The stocks also will appreciate by at least 5 per cent over the next 12 months according to Goldman individual company analysts.
Despite Goldman’s call and the big move in yields this week, some investors believe low inflation and a slow-moving Fed chief will keep real rates (nominal yield plus inflation) in favourable territory for bonds.
In fact, Goldman’s own economist, Jan Hatzius, told CNBC Friday he expects quantitative easing to continue well into 2014. (Read More: Bond Buying Will Go On for Long Time: Hatzius)
“My expectation is QE is still going to run for a long time through 2013, even 2014 at a reduced pace,” Hatzius said in a“Squawk on the Street” interview. “That obviously is only going to become clear over time and it’s going to depend on the economic data.”
Hatzius isn’t alone, either.
“It’s a long journey to the higher yields many speculate on,” said Tony Crescenzi, market strategist for PIMCO, the largest bond manager in the world. “Real interest rates today are deeply negative and the high level of unemployment limits inflation risk. Moreover, with the U.S. population ageing, investors will prefer to stay high in the capital structure, especially with the memory of two shocks in a decade.”
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