Thursday, June 9, 2011

Bond Market Considerations

At the beginning of the year, we alerted readers of our Outlook to be sensitive to the risks of investing in U.S. Treasury, corporate, and tax-exempt bonds. Our view rested on the historically low yields provided by these bonds at a time when the economic expansion was maturing and inflation was looming. We were also concerned about the U.S. government’s massive budget deficit and approaching debt ceiling deadline, highlighted recently by warnings of potential downgrades from credit agencies, and the very weak fiscal circumstances of many tax-exempt issuers. Our advice was to keep credit high and maturities short.

To our surprise, the yield on the benchmark 10-year U.S. Treasury note has declined from a high of 3.74% on February 8 to 2.95% on June 8, and corporate and tax-exempt yields have correspondingly declined. We attribute this drop in yields (and rise in prices) in part to growing uncertainty regarding the duration and severity of the current global economic “soft patch,” which has triggered an exodus from equities and a flight to the perceived safety of bonds in general and U.S. Treasury securities in particular. Another contributor to sliding yields has been the determined effort of the Federal Reserve to alleviate fears of inflation and keep rates low in hopes of accelerating economic growth.

Our forecast, shared by a consensus of economists, is that the “soft patch” will be relatively short and innocuous, as was the case with a similar “soft patch” at this time last year. A restoration of more healthy economic growth will most likely heighten inflation anxieties. We also expect the Federal Reserve’s “quantitative easing” policy (QE2) of purchasing Treasury securities to support low yields to expire in June and not to be extended.  Further, we expect worries about the U.S. government’s deficit to intensify as the debt ceiling deadline approaches. As a consequence, we reiterate our strategy of maintaining high quality and short maturities in U.S. bonds even though lower quality and longer-maturity bonds currently provide higher yields. We also suggest that readers consider the appeal of international bonds as an addition to U.S. bonds.

Our recommendation is echoed by Bill Gross, the celebrated manager of Pimco’s Total Return Fund, which is the world’s biggest bond fund. Gross, who according to  Bloomberg (6/9/2011) has outperformed 99% of his rivals over the past 5 years, eliminated U.S. government debt from his portfolio in February. Stating yesterday “I certainly don’t have any regrets,” he repeated his prediction that the 30-year bull market in bonds is over. Rather, he encouraged investors to consider the bonds of other countries with stronger balance sheets and half the debt. In particular, he cited the bonds of Germany, Canada, and Brazil, which have higher yields and he believes are safer credits, as “better opportunities.”

We point out that many factors need to be considered in evaluating the appropriateness and desirability of international bonds, and currency fluctuations will have a significant impact. Investors who want to control risk should favor intermediate-maturity, attractive-yielding sovereign bonds of countries with strong economies and currencies. We are currently reviewing portfolios on a client by client basis, and we strongly advise other readers to seek professional assistance in diversifying their bond holdings by taking a global perspective.

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