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1. OVERVIEW - WHY BONDS ARE BAD AND DANGEROUS OVER 5-10 YEARS

Within the US, UK, and Europe, there is likely a bond bubble going on currently, with artificially low yields due to central bank intervention and asset purchases in bond markets. A sluggish economic environment combined with further quantitative easing and uncertainty surrounding the European debt crisis will most likely weigh on long-term yields. With unemployment high and inflation low, the Federal Reserve is likely to continue to maintain extreme monetary policies, thus depressing US Treasury yields. We expect long-duration bonds will fare the worst, while sectors of the fixed income market with credit risk outperform as risk appetite returns.

My general advice now: Avoid all bonds. Or stick to low maturity cash-like options from countries like Canada and Australia.

But if you have to invest in bonds, the most effective ways to access bonds are through active or passively managed ETFs (lowest transaction costs plus good diversification). We prefer to take some credit risk to seek yield but we generally want shorter maturities and duration with high cash flow yields. Hence high yield corporate bonds issues, through an ETF, is our preferred space. To the extent that spreads compress further and yields stay low, we would prefer cash or other liquid measures over any fixed income.

10-Year Bond Yields are at Multi-Decade Lows and Are Close to 1940s and 1950s Lows

2. SOVEREIGN AND MORTGAGE BONDS

We have decided to allocate 8% of the portfolio to fixed income, which is one-half of our long-term fixed income portfolio target allocation of 16%. We are underweight fixed income relative to previous allocations because we are concerned about its near-term performance outlook. A further fall in 1-year UST yields seem extremely improbable, while a rise over 12-24 months seems likely. Our rationale for this concern is (i) fixed income is currently trading at a premium on a historical basis and appears overvalued; (ii) benchmark UST yields are near 50-year lows in the US and gilt yields are near 300-year lows in the UK; and (iii) there is limited upside potential for principal appreciation.

We expect that over 10 years, the purchasing power of the USD and fixed income securities will be significantly lowered due to:

i) High and volatile inflation as economic growth picks up and the velocity of money increases (we think inflation will be 100-300bps higher than the current approximate 2.5% breakeven level implies).

ii) Continued financial repression (negative real yields in many core instruments), as detailed in the Reinhart paper “The Liquidation of Government Debt”.

iii) Further quantitative and qualitative easing asset purchases, after which the Fed won't be able to contract its balance sheet, leading to classic monetary inflation in 2-4 years.

Breakeven Inflation Rates are Too Low Due to Fed Purchases and an Exploding Fed Balance Sheet

Finally, mortgage bonds also seem unattractive due to extreme Fed intervention through Fannie and Freddie to support mortgage bond markets. We would like to note that the 30-year conventional mortgage rate is significantly below its 40 year low. Hence any upside in mortgage bonds is superseded by the downside risks.

Mortgage Yields are at Multi-Decade Lows - The Biggest Owner of Agencies is the Fed

3. INVESTMENT GRADE CORPORATES, HIGH YIELD CORPORATES, AND STRUCTURED BONDS

Most investment-grade bonds look unattractive due to 50-year low yields last seen in the 1960s. Yet investment grade spreads and high yield spreads over USTs look decent compared to last ten years. We think this is deceptive due to the artificially low UST yields due to monetary and quantitative easing.

Investment Grade Bond Yields are at Multi-Decade Absolute Lows, Though Spreads seem OK

If forced to invest in bonds, high-yield bonds are the best of a bad lot because they have low duration (due to a higher coupon) and decent cash flow yields. Yet high yield bond spreads are not necessarily cheap/low either. Spreads at 750bps above USTs are interesting and 900bps above are attractive. Current spreads in the 600bps range are merely acceptable, given our low allocation. Our preferred vehicles for high-yield bonds are ETFs like JNK, HYG, and PHB. Our strategy here is to hold a shorter duration index and clip the coupons – the risk behind this is if rates rise quickly, we can get hurt fast. Finally, structured finance vehicles like CMBS are too new and have high product risk – it’s hard to get exposure there and so for now we would like no allocation to them.

High Yield Bonds with Low Duration are the Best Offering of a Bad Lot

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Source: A Global Bond Bubble