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Last updated October, 2014

If you’re among the astute investors who have made money in long-term bonds in 2014, congratulations. Coming into this year, the conventional wisdom said that long-term bond yields had nowhere to go but up. meaning that prices would fall. Those who bought or held on to their long-term bond funds made a truly contrarian call, and have benefited as yields declined through the first seven months of the year.

At this point, however, continuing to hold long-term bond funds is akin to picking up the proverbial pennies in front of the freight train. With significant downside and limited upside, the risk/reward trade-off is no longer favorable.

First, a Look Back

To get a sense of where the market may be going, it pays to take a brief look at how we got here. The 10-year and 30-year U.S. Treasury issues closed 2013 at 3.03% and 3.96%, respectively, and slid to 2.55% and 3.32% at the end of July. This was a major positive for long-term bond funds: in the first seven months of the year, the iShares 20+ Year Treasury Bond ETF (TLT) gained 13.6%, while PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ) gained 23.9%.

The reason for these gains is multi-faceted. In the first seven months of the year, long-term bonds benefited from a wide range of positive factors, including slower-than-expected economic growth, tame inflation, falling yields in other developed markets. and a favorable balance of supply and demand. Together, these trends more than offset the steady reduction in the size of the U.S. Federal Reserve’s bond-buying program known as quantitative easing .

Why Now is the Time to Take Profits

With such strong gains already in the books, it will take a nearly-perfect environment for long-term bonds to keep producing gains. Perfect, for the bond market, would be a surprising collapse in economic growth – an event that doesn’t appear to be on the horizon absent a truly unexpected development.

On the other hand, five factors stand out as reasons why longer-term debt will begin to face headwinds:

Stronger growth. While the U.S. economy slowed down significantly during the winter months with a first quarter contraction of 2.1%, the consensus view has been that this was entirely the result of the unusually harsh winter weather. This has been validated by the second-quarter gross domestic product growth, which showed an expansion of 4%. Coming on the heels of 2013’s strong second half, it appears that – absent the impact of the winter weather – growth is indeed accelerating. If this is indeed the case, it’s clearly bad news for bonds.

Inflation. Low inflation has been a significant pillar of bond market performance in recent years, as discussed here. However, the PCE index (which stands for Personal Consumption Expenditures) rose at an annualized rate of 2.3% in the second quarter, up from 1.4% in the first three months of the year. This marked the highest quarterly inflation reading in three years. If inflation is in fact accelerating, the Fed could be forced to raise rates sooner than expected – a development that would lead to a major reversal in long-term bonds’ recent positive performance.

Fed policy. The Fed’s plan to begin raising interest rates in 2015 is probably one of the most heavily-telegraphed events in the history of monetary policy. This takes away the element of surprise, which is usually what pressures market performance (more so than a news event on its own). Still, the end of quantitative easing – together with the fast-approaching date at which the Fed will begin raising rates – is an adverse development that could begin to pressure market performance. Even worse, the potential still exists for the Fed to accelerate its timeline — a negative surprise that would weigh heavily on market performance.

Sentiment. For reasons outlined here. markets tend to perform better when investors are nervous and skeptical rather than being bullish. The basic idea: if everyone agrees an investment is a great idea, there’s nobody left to buy. That may be the case right now, as bullish sentiment on bonds reached record levels in late July – as outlined here by Mark Hulbert of CBS Marketwatch. Sentiment can change quickly, of course, but for now the lack of fear in the bond market is – somewhat counterintuitively – a bad sign for future performance.

Short-term bond yields are already rising. Even as long-term bond yields have fallen this year, yields on 2- and 3-year Treasuries have risen and the five-year note closed July just short of a 52-week high. Eventually, the disconnect between short- and long-term bonds will resolve itself. With the economy picking up steam and the first Fed rate hike drawing closer, this resolution is more likely to occur with an increase in long-term yields rather than a decline in short-term rates.

What are the Risks to this Prediction?

All of the above assumes a lack of surprising headlines. A wider conflict in the Middle East, unforeseen geopolitical events, a sharp downturn in the European economy, or a severe stock-market downturn are all factors that could lead to a rally in longer-term bonds at some point in the next six months. All else equal, however, the tide appears set to turn against long-term bonds.

The Bottom Line

If you hang on to your long-term bond fund the best hope is to eke out a couple of more percentage points of gain, but the potential downside is much more substantial.

As a result, now is the time to consider selling your long-term bond fund. As the saying goes, nobody ever went poor taking profits.

Disclaimer. The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.