The cries warning us about a so-called bond bubble have been emanating ever more loudly from the street. Sages warn is that there is more upside risk to interest rates than down side reward. No kidding, did theses financial oracles figure this all out on their own? With the Fed funds rates effectively zero and the 10-year not hovering around 2.50% it doesn’t take a rocket scientist or some one with supernatural gifts to draw that conclusion. However, low rates to not a bubble make.
A bubble occurs when investors pile into an asset class, market, etc. irrationally. When calmer heads prevail and profit taking begins the bubble bursts. However, there is nothing irrational about today’s interest rate levels. Inflation is relatively tame. Job growth is lackluster. Banks are disincentivized to lend for both economic and political reasons. Consumers are still over leveraged. What in the world, outside an exodus from the dollar by investors large and small would push rates higher at this time? The answer is nothing, yet.
The truth is that the ability for investors to exit the dollar en masse is limited. Consider this: Gold hits a new high nearly every day. Some foreign central banks are actively, if not desperately, trying to halt the rise of their currencies. Yet long-term U.S. rates remain historically very low. Some of this can be attributed to quantitative easing and the threat of QE2, but it is more the reasons why more QE may be necessary, not the QE itself which is keeping rates low on the long end of the curve.
What are the reasons the Fed believes more QE may be necessary?
1). Consumers are not borrowing. It is true many are simply over leveraged and cannot borrow, but many do have access for credit but see little need to borrow. The Fed hopes to keep rates low (if not push them lower as has happened since the threat of more QE was announced) to entice those who can obtain credit to come off of the sidelines.
2) Businesses benefit from low borrowing costs. U.S. corporations have flooded the market with new debt. Large bond deals have come to market almost every day for the past several months. This cheap source of borrowed funds, which provide debt service expense savings, have contributed to stronger balance sheets and higher profits. If consumers spend less and business activity is modest, the Fed has helped make transactions which do occur more profitable. As evidenced by the Durable Goods. GDP and regional business activity reports, businesses are using this cheap source of funds to buy new, more efficient equipment. However, this does little for hiring.
Some economists have pointed out that increased higher has always followed such spending. This may again be true, but the hiring which does take place may be smaller in scale than in the past, pay lower wages than to what workers have become accustomed and may be created off shore.
3) The third reason is policy-driven economic headwinds. Higher business and personal taxes, unclear effects of new healthcare legislation (apparently HHS secretary, Kathleen Sebelius will have a good amount of discretion to decide which corporate health plans are acceptable and which are not. It is good to be the queen.), concern among banks as to what their capital requirements will be and anti-business rhetoric from the Obama administration are doing much to dampen growth.
Businesses don’t have to hire. Consumers don’t have to spend beyond sustenance levels and banks do not have to lend if the reward of doing so does not justify the risk. No amount of Capitol Hill bluster is going to change that. Many pundits have pointed to one of my aforementioned reasons, but it is truly all three which are responsible for the disappointing recovery.
The upshot of this is that rates will stay low for an extended period of time. Cash is not the place to wait as rates are punitively low. The long and of the curve is not an optimal destination because a 100 basis point rise in long-term rates could result in 10+ point price declines on bonds.
There are ways to soften the blow of rising rates without holding in cash with very little yield. One can ladder. Not all areas of the curve lose value in the same fashion. Like everything in life investing is about balance. While a 30-year bond may lose 12 points worth or principal value for a 100 basis point rise in rates a 10-year bond may lose 7 points, a 5-year bond 3 points and a 2-year bond only one point. By laddering ones bond portfolio, possibly focusing on the so-called belly of the curve (5 to 7 years out), as it is usually the most stable in a changing rate environment, one can obtain decent yields without taking excessive interest rate volatility.
One also should understand that not all bonds react the same way to changing interest rates. Some bonds, such as U.S. treasuries, are interest rate products. Where rates go, they go (the Fed influences the short end while inflation expectations influence the long end). However, some bonds, such as corporate bonds are credit products. Although interest rates an affect their trading levels. Their credit spreads versus treasury benchmarks also play apart. The changing of credit spreads due to balance sheet strength or weakness and investor demand for portfolio diversification can affect credit spreads.
We have seen this in action. In the extreme we saw yields for bank ad finance bonds rise in 2008 and early 2009 even though treasury yields fell. Their credit spreads widened due to balance sheet and viability concerns. Their yields did not follow interest rates. Once it became apparent that the largest banks were not going to fail, their credit spreads narrowed (to a point) and their yields fell more than treasury yields for a period of time. Less volatile sectors such as utilities and companies in the consumer product sectors did not experience such spread widening and flowed treasury yields lower, often out pacing the drop in rates as credit spreads narrowed as investors looking for yield sold their bank bonds and purchased utility or industrial sector bonds hoping to get even a small yield pickup over treasuries.
Rising interest rates may be offset somewhat by purchasing bonds which are trading at credit spreads which remain wider than their historic norms. This leads us back to the banks. Bonds of the large money center banks and large regional banks are still trading wide to treasuries. In some cases 50 to 100 basis points wide. If rates rise due to an economic recovery, these credit spreads could narrow 50 to 100 basis points effectively offsetting the first 50 to 100 basis point rise in long-term rates.
However, the story could be very different for bonds in other sectors. In an effort to earn returns above treasuries, but take on minimal risk, many investors purchased bonds in less volatile sectors and companies. If rates rise due to improving economic conditions, investors may sell their bonds trading at very tight spreads (MSFT, WMT, JNJ, etc.) and buy bonds in sectors or companies that were, until now, a bit to risky for their tastes (BAC, MS, GS, etc.). For this reason the yields of industrial sector bonds could rise even faster and more sharply than treasury yields as their safety is no longer needed.
When investing in fixed income one must understand the mechanics of the various products. By mixing in credit products with interest rate products and spreading ones assets across the curve (only out to10 years or so as one can pick up 75% of the slope of the curve without incurring the volatility of the very log end of the curve). One can earn attractive returns without being blown up by any bursting “bubbles”
I forgot to mention: Preferreds are rich and floater to not necessarily protect you from rising rates. It all depends on how much they float, off of what benchmark they float and off of what benchmark they trade.
Later.
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