The Bond Investor's Dilemma

Bond investors now confront a dilemma similar to the one faced by stock investors. Broadly speaking, credit markets have had such a strong advance this year that markets now appear stretched and valuations are uninspiring. Accordingly, bond investors looking to allocate new capital are probably best served by waiting for a better entry point or sticking to shorterterm, high-quality investments.

The challenge faced by investors seeking a respectable and reasonably secure stream of income from bonds is this: on one hand, you want to protect yourself against future inflation risk, which is accomplished by keeping the average maturity relatively short (i.e. under five years). On the other hand, you can't bring the average maturity in too far without damaging the income flow, due to the Fed's zero percent interest rate policy and the resulting steepness of the yield curve. Cash is unattractive, because you don't want to earn a negative real return. Meanwhile, yields on lower-quality bonds, such as high yield corporates, no longer seem to offer any margin of safety.

Such is the result of the massive government intrusion into the market pricing of credit. The Federal Reserve hasn't been buying corporate bonds directly, but its purchases of mortgage bonds (and Treasuries), combined with its zero percent interest rate policy, has aided recovery in the corporate bond market. So far, the Fed has purchased $850 billion of mortgage-backed securities, and has been buying 80% of new mortgages. The Fed recently extended its mortgage-buying program to March 2010 and indicated that it will spend $1.25 trillion in total. Federal Reserve intervention has provided "cover" for bond investors, and that support is continuing, but investors need to be mindful that bond market pricing does not reflect true market conditions.

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Comments

[Alan Young:]

"Such is the result of the massive government intrusion into the market pricing of credit." But that was exactly what the government intended: make savings unattractive, to increase investment in riskier assets and to increase money flow (M2), which has fallen to a fraction of what it was when the economy was healthy.

It's a dilemma for bond investors, indeed; but it's a feature, not a bug, of Fed policies.

Oct 13 01:42 PM

[Daniel Eskin:]

Well said Alan. I agree with the comment above that the Fed is just acting as it naturally feels is appropriate, despite that everybody out of the Fed feels it is the incorrect move.

Check out my blog at www.youngandinvested.com

Oct 14 10:04 AM

[MexCom:]

As much as the Fed was wrong during the low interest rate greed fueling along with the deficit spending increase with poor tax policy from the Bush administration - the current rescue with zero interest rates from the Fed seems the right thing to do and to continue until a strong rebound is evident.

This policy is saying to the market - now is the time to accept risk and buy those junk bonds - the yields have declined. The decrease in the rates of return for preferred stocks has also been phenominal but these rates continue to to be 2 times and more the yield of Long term treasuries and AAA rated securities.

Inflation is key and the fed will step in to increase rates when needed. This would seem to be a factor to increase the rates of return on yields but for long-term bonds, this would signal a resolve to keep inflation low and yields would decrease further.

Its a no brainer to me that now is the time to buy long-term bonds and preferred stocks. You can still lock in good returns and as these rates decline from decreased percieved inflation risk, captial appreciation would offset any fear of not being able to capture increased coupons with newly issued short to medium term instruments.

Oct 14 11:07 AM

[Dr.Jackpot:]

The story continues and is the same. Money has to come from somewhere so "shaft the savers" (but keep touting to save) and entice young spenders to buy, buy, buy. Give'em the free money you just stole from the savers. Don't pay any interest on the $250,000 the retiree has in the bank. He's old and can get by on beans. The young guy needs a new convert and look at the profit we will get. No one will challenge Greenspan or Bernanke since the 'take' is free.

Oct 14 01:43 PM