A Strong Out of the Gate Start for Fixed Income

by: Christopher Keith

The New Year started on a positive tone for domestic markets as all of the major fixed income indices we follow posted positive performance for the month of January. Many of the index returns were within striking distance of one another, so we cannot say that any one particular fixed income asset class far outpaced the others.

Inflation-linked bonds led the way in the higher-quality arena, but they only edged out nominal Treasuries by less than a handful of basis points. At the same time, the trend in credit, both investment grade and speculative grade, continued to the up side. We remain constructive on the high yield asset class even after last year’s stellar returns. With an improving economy and an expected sharp decline in the default rate as the backdrop and part of our rationale, we like high yield, but suggest investors use a mutual fund instead of investing in the individual company’s debt.

Toward the end of the month, investors became somewhat concerned with holding the sovereign debt of the Hellenic Republic (Greece) as the global recession’s impact is being felt there perhaps a little more than originally expected. Some argue that this is a concern for the whole Mediterranean rim area (Greece, Spain, Portugal and Italy). Greece is dealing with an outsized deficit and one consequence is downward price pressure on their bonds.

A Bloomberg news story I read states that

Greek officials are struggling to convince investors that the government will be able to cut the deficit from an EU-high 12.7% of GDP last year to below the bloc’s limit of 3% by 2012. The premium investors demand to hold Greek 10-year bonds widened to almost 400 basis points last week (end of January), the highest since the year before the Euro’s debut in 1999.

As February began that spread started to diminish, signaling that at least some investors see value in Greece’s debt and are prepared to take on that risk.

From my perspective this is further confirmation of why it is prudent to balance and diversify portfolios with multiple exposures not only among asset classes, but also within asset classes. Maintaining a global exposure where appropriate can be beneficial to portfolios and investors should not be discouraged away from doing this because of this most recent concern.

Economist David Kelly, PhD and Chief Market Strategist for JPMorgan Funds, visited our offices in Wellesley, Massachusetts recently, which is always a learning experience we welcome. I have followed and respected Dr. Kelly’s opinions for a good while and find any time spent with him to be very worthwhile. This time around his visit happened to coincide with economic data releases that, for the time being anyway, are showing signs of improvement. It was a good chance for me and the research staff here at Kobren Insight Management to pick his brain a bit and gain some insight as to what he expects in the year ahead.

Regarding his observations on the economy, he believes there is no reason why we shouldn’t see a decent recovery.

People under appreciate the resilience of the economy because they were so beaten up in the past. If we do get into a double-dip recession, it will be because of an unexpected shock, not because of bad economics.

Regarding the unemployment rate, Dr. Kelly felt the bad news on the jobs front is that it will take years for the unemployment rate to go down. Unemployment tends to rise 2% per year on the way up and falls by only 1% per year on the way down. With an unemployment rate of 10%, it could take 5 years to get back to a 5% unemployment rate. Jobs growth always lags, but we have turned the corner.

Dr. Kelly’s final words were about inflation, which is something I have focused on many times in the past. Basically, he sees no inflation on the horizon and says that even if we did the Fed could quickly and easily confront it with a series of rate hikes to stem unwanted levels should they occur. Deflation, on the other hand, is the greater threat and that is not so easy to stop.

Regarding the Fed, he says their biggest challenge is managing expectations. He thinks they should consider raising the Fed Funds rate to 0.50% and accompany that action with some decisive wording that says two things: 1) The immediate financial crisis is over and an interest rate of 0% is no longer necessary; and 2) We expect to leave the Fed funds rate at .50% for quite some time.

The investment ideas and expressions of opinion may contain certain forward looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities.

Kobren Insight Management’s statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part II, which describes, among other things, affiliations, services offered and fees charged. Past performance is not an indication of future returns.

Disclosure: None