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.
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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