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Thursday, April 18, 2013

Q 1 2013 Credit Market Review and Strategy

If there was a message of the fixed income (bond) market this quarter it was that investors have finally decided that the risk return on intermediate and longer term bonds has tilted away from bonds. This triggered a small selloff in intermediate and longer term bonds in anticipation of an eventual end to Federal Reserve’s easing policy if not through outright interest rate increases at least in the form of an end or reduction in bond buying (“quantitative easing/QE). Nonetheless, with economic data mixed there is certainly no decisive “bursting” of the bond bubble.
It seems as if the close to 20 years of largest in history declines in interest rates (see below for 10 year treasury and corporate investment grade bonds since 1963 ) is running to a close. Simply on the basis of arithmetic, since rates cannot go below zero, the gains of previous years simply cannot be replicated.
Intermediate Term Bonds (Treasuries Blue, Corporates Red)

Nonetheless as of this writing (April 16)recent economic data still point to weakness in the economy and low near term inflation giving some gains to intermediate and longer term bonds. We still see the risk/return as with one exception—Build America Bonds—as unattractive.
Treasury bonds:                         
Treasury bonds carrying the lowest yield of all sectors of the bond market performed the worst of the key bond sectors as seen below The low yields were not enough to offset much of the price changes.

Investment Grade Corporate Bond
Investors willing to take moderate credit risk were rewarded for taking the risk with modest gains.

High Yield (junk bonds) Investors in search of yield have invested record amounts into high yield bonds pushing yields and credit spreads to record lows. The conventional wisdom is full of talk of a high yield bond “bubble”.  I view that analysis as simplistic. If the major cause for higher interest rates is an improved economy than it doesn’t follow that high yield bonds will suffer more than other bonds of similar maturity in the treasury and investment grade sectors. After all the low rates mean  that companies have refinanced at lower rates that factor and an improved economy would mean better prospects for the weaker credits that issue high yield debt.

Strategy: Finding value in the bond market.

Risks of price declines in bonds that reduce or erase total returns (interest earned + price change) come in two types: credit risk and interest rate risk.

Interest rate risk: Higher market interest rates cause declines in the bond market and the longer the maturity (or more precisely duration) of bonds the greater the price declines. Based on current market levels the risk return of intermediate and long term bonds argues for shortening maturities despite the lower yields.

Credit Risk: In terms of risk/reward tradeoff taking on a higher credit risk seems a better way to pick up yield. As noted an improved economy reduces credit risk and short term bonds carry minimal interest rate risk as their price sensitivity to interest rate changes is far lower than on intermediate or long term bonds.

This would argue for looking at the following mutual funds and ETfs s as components of a bond market allocation. '

In a conservative allocation such  one is just looking for minimal price fluctuation such that total return = yield for the short term bonds and a price risk that is high enough to offset price fluctuations for the intermediate term bond fund…with some potential for upside.

  • GNMA bond funds: these funds are short duration and the instruments carry the full faith and credit of the US Government but have yields above treasuries. Although recent total return has been hurt by the vagaries of Fed purchases of mortgage securitie they still merit considering in asset allocation.  Current 30 day sec yield is 1.69%
  • Short term investment grade corporate bonds…a little more credit risk than the above  for a bit higher yield  and a bit more price volatility 
  • Short term high yield bonds. For those willing to take on more credit risk short term high yield (SJNK) looks quite attractive. The yield is around 4.25% and the price has proven to be very stable. All an investor is looking for in this area of the bond market is minimal price movement allowing the investor to capture the yield.
  • Intermediate term bonds. For those willing to take on a bit of interest rate risk as a “hedge” against going all in on a view of rates going higher in the near term there is one sector of the intermediate bond market where risk/return look reasonable. Build America Bonds essentially muni bonds with the Federal government assuming partially the cost of debt payments. In other words these bonds offer a cushion against possible price declines due to higher interest rates and good potential for price increases should rates move down a bit  BAB currently yields a bit over 4%/
  • Treasury bills instead of money market. Investors who currently have some holdings in money market funds might consider a tbill etf like SHY as an alternative.  Money market funds are not credit risk free in 2008 a major money market fund “broke the buck” fell below $1 in net asset value. Although the Fed effectively bailed out the fund and its investors to protect the $1 net asset value, there is no guarantee this will occur in the future. On the other hand treasury bills are a crisis hedge.                                                                        Despite their near zero current yield they are likely to rise in price in a financial crisis. In 2008 SHY had a total return of 6%  while money market returns guaranteed no price fluctuation but paid virtually zero interest  making total return = yield . And  money marke funds carry more credit risk than treasury bills. Thus treasury bills act as a bit of a “crisis hedge”. 
  • ” Combining some treasury bills with short term high yield in their portfolio. This would be a “barbell strategy “with regard to credit risk while retaining low interest rate risk. As rough example a 50/50 split between SJNk and SHY would yield  a bit over 2.55%    Of course increasing the weighting of SJNK would raise yield--(and increase credit risk—risk and return are (almost) always linked at the hip.

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