Bonds: Nothing to Fear But Fear Itself

Why the sell-off is healthyand higher rates may signal a stronger economy

Seal the windows. Stock up on bottled water, energy bars, and BlackBerry batteries. Be ready to kick off your $250 wingtips and run for your lives. Prepare, Wall Street, for certain destruction at the hands of…5% interest rates! That, anyway, has been the reaction of many to the violent sell-off in U.S. Treasury bonds this month that has sent interest yields spiking. (When the demand for bonds fades and prices fall, their yields rise, and vice versa.) The yield on the benchmark 10-year note touched a five-year high of 5.33% on the morning of June 13, up from just 4.56% two months earlier.

To many cable-TV pundits and investment strategists, the rout is a harbinger of doom. Put in the proper context, however, it's anything but.

Conventional wisdom holds that higher rates endanger both investors and the broad economy. They mean greater borrowing costs for companies and consumers, threatening economic growth and profits. They signal expectations of rising inflation, which erodes the real returns on all investments. They make it more expensive for private equity firms to take on debt to buy out companies at big premiums, a practice that has buttressed the nearly five-year bull market for stocks. And at the most basic level, higher rates on "risk-free" Treasuries make riskier assets such as stocks and corporate bonds less appealing.

But Treasury yields are like Rorschachs, revealing more about the mindsets of their observers than any intrinsic certainty in themselves. One could just as easily argue that rising rates are a healthy symptom of a strengthening economy. After all, the post-September 11, post-Enron economic funk prompted the Fed to slash its target short-term interest rate to 1%, an emergency measure that pushed Treasury yields to just a hair above 3% in 2003. The recent uptick, say many yield watchers, was long overdue. We might even dare to welcome it.

Low Long-Term Rates

For all the commotion over the worst bond market sell-off in four years, long-term rates are still low by recent historical standards. The 10-year Treasury yield hit a staggering 16% in 1981 and closed that decade at a still robust 8%. "During the '80s, investors would recoil every time we went below 8% or 7%," says Brian Wesbury, chief economist at First Trust Advisors in Lisle, Ill. "It was like, ‘I'll never buy a bond for less than that.' Now it's the opposite: fear on the way up." Yet long-term rates have merely revisited their two-century average of 5.25%, according to Lehman Brothers (LEH).

The June swoon follows a long stretch of ultralow rates. At 5.33%, the 10-year Treasury recently yielded slightly more than the Fed's target rate of 5.25%. Yet for the preceding year and a half it yielded far less, a rare situation that historically has been a sign of weak growth expectations if not looming recession. The realignment shows a return to normalcy.

There's nothing bad about that. "The Treasury yield is roughly where it should be," says veteran economist Sung Won Sohn of Hanmi Bank (HAFC) in Los Angeles. "What we had was too low."

Private Equity: Still Kicking

Higher interest rates also illustrate the strength of the global economy as new investment opportunities are making it tougher for foreign investors to justify parking funds in comparatively boring U.S. government debt. "Central banks are now beginning to toy with the idea of taking part of their reserves out of Treasuries and putting it into alternative investments," says David Rosenberg, North American economist for Merrill Lynch (MER) Even so, it's hard to imagine the cash-flush Chinese forever avoiding Treasuries that yield 5.30% merely weeks after they were snapping them up at 4.50%.

Don't pronounce the private equity boom dead, either. Many big leveraged buyouts are actually financed with loans based on an interest rate set on a different continent: the London interbank-offered rate. Despite all the panic in the U.S. bond pits, that figure has held steady. Low rates there should keep money flowing into buyouts, underpinning the U.S. equities market.

This bond monster just isn't all that scary.