2009 Fixed Income Roadmap: 8 Actionable Ideas

Includes: DIA, QQQ, SPY
by: Mark Hines

With the likes of Warren Buffett recently claiming now is the time to get long equities, why would anyone even consider fixed income? With the S&P500 offering more and more value with each passing month, it seems now is the time to get long and stay long the stock market. Ten years from now won’t we all be looking back and saying “Wow! 2009 was one of the best times in history to buy stocks!” However, believe it or not, there are some very smart people who are actually investing in fixed income; for example some can’t stomach the volatility of stocks, others like the income stream, and still others invest in fixed income as part of their overall diversification and asset allocation strategies. In this 2009 Fixed Income Roadmap, I provide an overview of the current landscape of the Fixed Income market (as I see it), and I’ll offer eight actionable fixed income trading ideas.

Let’s start with Treasuries. I can sum up my thoughts on the US Treasury markets in three simple words: Don’t buy Treasuries. With the 30-year Treasury offering around 2.8% and the 3-month Treasury hovering around 5 basis points (and occasionally dipping into negative territory!), it makes little sense to invest in US Treasuries. I understand the global credit crisis has people scared, but there are still far better fixed income investment opportunities than US Treasuries.

Actionable Fixed Income Investment Idea #1: Short Treasuries. There are a variety of ways to implement this strategy (for example my colleagues Todd Chalem and Andy Greig like trading ratio spreads on Treasury ETFs and the Treasury carry trade, respectively), but the bottom line is to avoid Treasuries.

Government Guaranteed Bank Debt is an extremely viable alternative to Treasuries. In case you haven’t heard, the US (and European) Governments have implemented a variety of new policies to counter the global financial crisis, and Government Guaranteed Bank Debt is one of them. Government Guaranteed Bank Debt represents a new fixed income class, and an extremely attractive one in my opinion. For starters, the Federal Deposit Insurance Corporation [FDIC] has guaranteed new issuances of senior unsecured debt for a variety of banks. For example, Bank of America (NYSE:BAC), Citigroup (NYSE:C), GE Capital (NYSE:GE), and Morgan Stanley (NYSE:MS) have all issued debt under this program.

Currently the FDIC is guaranteeing this debt as long as it’s issued before June 30, 2009 and is due before June 30, 2012. Yields were originally over 3%, they’ve fallen to around 2%, and they’ll likely continue to narrow the spread on Treasuries as people continue to recognize their value. However, a 2% yield on a 2-year Government Guaranteed Bank Debt security is a lot better than the 75 basis points that 2-year Treasuries are offering.

Certificates of Deposit are also better than Treasuries. CD’s are boring, right? Well, that depends on who you are and what your goals are, but if you’re looking for a good alternative to Treasuries, CD’s are attractive. Yields on 1 year CDs are over 3% and 4% at many banks, and the FDIC has increased its insurance from $100,000 up to $250,000 per bank through December 31, 2009. In fact, yields on 1-year CD’s are so attractive compared to Treasuries that I saw one client actually purchase over 100 $250k CDs (each one from a different bank) just to take advantage of the large spread over Treasuries and the FDIC guarantee.

Actionable Fixed Income Investment Idea #2: Buy Government Guaranteed Bank Debt or FDIC insured Certificates of Deposit to earn guaranteed yields that are often more than 3% higher than Treasuries.

Pre-Refunded Municipal Bonds are another great alternative to Treasuries for low risk investors. Yields on many of these often AAA rated bonds are over 2% for two years and over 5% for 30-years and the payments are pre-refunded with US Treasuries (i.e. the municipality issuing the bonds has set aside 100% of their obligations in a trust that holds only US Treasuries). This makes for an extremely safe investment, not to mention the added benefit of the even higher tax-equivalent yield created by the tax-exempt status of many of these bonds.

.Actionable Fixed Income Investment Idea #3: Short Treasuries and Buy Pre-Refunded Municipal Bonds.

Treasury Inflation Protected Securities [TIPS] offer better yields than Treasuries. The idea of TIPS is that the yield on these Treasuries increases to account for inflation, and given the fact that the US Government is throwing money everywhere (via bailouts) it’s very reasonable to assume we’ll be seeing some serious inflation in the years ahead, which makes TIPS even more attractive compared to straight Treasuries (and I’ll have more to say on inflation later).

.Actionable Fixed Income Investment Idea #4: Buy TIPS instead of straight Treasuries.

Corporate Bonds are another great fixed income opportunity right now. Our current financial crisis has caused such an extreme flight to quality that investors purchased Treasuries to the point where yields are now negligible, and the side effect is great opportunity in corporate bonds. Investment grade corporate bonds are now often yielding in excess of 8%, and they still have default rates that are extremely low. The default rate on investment grade corporate bonds would have to increase to the levels of the Great Depression to warrant these high yields. Given we’ve seen some amazingly unlikely financial events over the last year, but I still believe investment grade corporate bonds are a great investment opportunity.

.Actionable Fixed Income Investment Idea #5: Short Treasuries and Buy investment grade corporate bonds.

Asset Backed Securities still sell at Fire Sale prices. Many investors are still dumping asset backed securities at “throw away” prices. They continue to look for opportunities to dump these high risk investments, and often get to the point where they want (or need) to get rid of them so badly that they sell them dirt-cheap. Often, institutional investors are looking to exit the entire asset backed category, and sell them without doing their homework. As I’ve written before, a little research into pre-payment speeds can turn up some fairly safe asset backed securities selling at massive discounts, and putting together a portfolio of these can result in some very large gains.

.Actionable Fixed Income Investment Idea #6: Be on the lookout for “fire sale” asset-backed security prices (you may have to work with your broker on this one as it could be challenging to find these types of bonds for sale in your online account).

.European Bonds are offering higher yields than comparable US bonds. For example, many European Government bonds (such as Finland, The Netherlands, and Belgium) offer AAA rated bonds yielding more than 200 basis points higher than comparable US Treasuries. Of course the big risk here is the fluctuating USD/EUR exchange rate. With recent monthly fluctuations of +/- 15% the extra 2% yield on these European bonds could be trivial.

.Actionable Fixed Income Investment Idea #7: Invest in European bonds to pick up extra yield (and hedge with currency futures contracts if you can’t handle the FX rate fluctuations).

.Gold Looks Cheap. I know gold isn’t a fixed-income investment, but I’d feel remiss if I didn’t at least mention it. With many interest rates so low right now, and a huge wave of inflation that seems inevitable, it makes sense to consider gold. Let alone the negative yield on 3-month Treasuries, the impact of inflation in the coming years may be overwhelming. For example, if inflation averages a mere 2% next year, that means any fixed income security you invest in that doesn’t offer at least 2% will actually result in a negative yield if you factor in inflation. Gold is often considered the closest thing to an “inflation-proof” investment, and with the front month Gold futures contract currently trading well below its highs of over $1000, you may want to consider investing in Gold.

Actionable Investment Idea #8: Invest in gold to protect yourself from the anticipated wave of inflation that could cause other asset classes to yield a negative real rate of return (my colleague Thomas Tan is very active in the gold market and he has a lot more to say about gold and inflation here).

Overall, the fixed income markets are in disarray. The extreme flight to quality has caused Treasuries to offer inexcusably low yields while other asset classes are offering far better opportunities. In fact, the low yield on Treasuries has created a variety of unique trading opportunities as outlined above. Of course if you believe now is the time to get long and stay long the stock market, then by all means go for it. However if fixed income is part of your overall allocation strategy then I’d think long and hard before you buy another Treasury.