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Last week the Fed announced its measures for another easing of the monetary conditions as most of the market participants expected. The markets cheered the move with equities rallying beyond their highest levels for the year and the U.S. Dollar dropping more than 2 cents against the euro. The EURUSD pair finished the week a bit above the 1.31 level and it looks like the euro is headed for more gains.

Interesting enough the yields on the long term US treasury bonds continued to rise despite the fact that the Operation Twist was decided to continue until the end of 2012. The yield on 30-y bonds marked a level of 3.04% for Friday. It is the first time since May 2012 the yield got this high, according to Bloomberg data. This opens the door for getting a higher income from a bonds portfolio using the simple low risk strategy described below. Such an option might seem counter-intuitive at first as bond prices are expected to fall but it is not so unreasonable having in mind the recent market expectations and economic developments.

Before the Fed announced its decisions last week, there was a tweet on Monday from Bill Gross, the head of PIMCO investment management firm in which he stated:

"Gross:Bond Investors--yield curves 2 be very steep in US&Euroland 4 a very long time. Reflation underway. Low short rates; higher long rates"

A Bloomberg article from Friday shows that bond investors might agree with him. Recent data on the U.S. Economy show the possibility of elevated inflation expectations among the market participants seems real. The Producer price index released on Thursday showed an unexpected increase to 2.0% (unadj.) for the last 12 months against a previous value of 0.5%. The main reason for this increase were the higher energy and food prices. It is worth noting that the Fed expectations expressed in the previous FOMC statement were that inflation would be subdued due to decreases in food and energy prices. Clearly this seems not to be the case.

The recent Friday data on the U.S. CPI show an increase of 1.7% in the inflation for the last 12 months. The monthly change of 0.6% is the highest one since June 2009.

For both of the increases the main reason were the higher energy and food prices. With the current third round of QE it is reasonable to expect that the U.S. dollar will continue to depreciate if a major disruption in the Europe does not take place. The recent political developments in the EU however could give a certain degree of optimism towards the political will to act. With the current upward trend of the euro in line, most of the reasons for which were already examined in an article here dated near the end of July, even a major risk event such as Spain or another troubled European country asking the ECB for help could hardly be able to do a significant and long term change in the EURUSD direction. Given this happens to be the case, the depreciation of the USD would bring a rise in commodity prices which could reflect directly on the energy indexes in the U.S. and Europe by bringing them even higher, thus promoting an increased inflation.

This is in line with what Mr. Gross wrote about the reflation process being undertaken. Whether this would be a successful policy or not is not the main point here as in both of the outcomes the inflation expectations should be elevated. The current Fed actions could promote inflation not just as a temporary condition but for the years to come. This would affect the long term yield curve by making the spread between the short term and long term yields to grow for a prolonged time.

The Strategy

As the shorter term rates are already at their lowest part of the range, the increasing spread would generally mean that as time passes the yield required by the market on the longer term securities should grow. Bond portfolio investors could use the expectations of a higher yield in order to try to secure a steady or even an increasing income for a time horizon of their choice. This could be a retirement or other type of income. Investing through a 401(k) or an individual retirement account could allow deferring of some taxes associated with bond investing but investors should consult a professional tax adviser on this issue.

The main idea of the strategy is that investors could acquire long term bonds now with maturity equal to their investment horizon (for instance 30 or 15 years) and invest the proceeds from the coupon payments in shorter term treasuries later, thus taking advantage of the expectations of higher yields due to an inflationary pressure. The purchased securities are expected to be held to maturity in order to be relieved from risks on their price and realize their expected yield. Such a strategy could provide a steady income for the holding time of the portfolio with a relatively low risk.

The strategy in its purest form is to be realized through direct purchases from the government as this would allow the investor to take a more tailored approach, take advantage of the current Treasuries prices and generally have a better risk control.

An investor who prefers using ETFs could gain initial exposure through Barclays 20 Year Treasury Bond fund (NYSEARCA:TLT) or the Barclays 10-20 Year Treasury Bond fund (NYSEARCA:TLH), both of which have an expense ratio of .15%. The disadvantage of using funds like those concerning this strategy would be that they track both the yield and the price performance of the bonds whereas the strategy chases yields and price is generally irrelevant as bonds are expected to be held until maturity.

Risks

The risks that generally affect debt securities include interest rate risk, foreign exchange risk, inflation risk, reinvestment risk, volatility and yield curve risks. Let us examine the effect of each of those on the projected strategy.

The interest rate risk which is one of the major risks in bond investing could be present given the rates do increase but as the bonds in this portfolio are supposed to be held to maturity and not resold, any negative changes in the bond prices will be compensated at the maturity by the realized yield and will have only a temporary effect on the portfolio value.

The domestic investors would not be exposed to a currency risk while the international ones could hedge this risk by using currency futures or currency ETFs. One candidate for such an ETF would be the DB USD Index Bullish fund (NYSEARCA:UUP) which replicates the performance of being long in the U.S. dollar against six other major currencies. In order to hedge an investment in U.S. treasuries an international investor could open a short position in the fund. Another option for hedging the foreign exchange risk is to be long in the DB USD Index Bearish (NYSEARCA:UDN) fund which is the same as the previous one but replicates the performance of being short the USD. Both funds have an expense ratio of .50%.

The inflation risk is present but on theory the yield required on the treasury notes and bonds includes an inflation premium so they should have a higher yield than the expected inflation. In order to protect against mismatches between the expected inflation and the realized one, an investor could use the inflation protected securities, the TIPS, with maturities shorter than or equal to the firstly purchased longer term securities.

TIPS could be purchased directly from the government for a better tailoring of the strategy or the investor could gain exposure to them by an ETF like the Barclays TIPS Bond fund (NYSEARCA:TIP). It tracks an index which includes all publicly issued U.S. Treasury TIPS that have at least one year to maturity. Other options are the 1-5 Year U.S. TIPS Index fund (NYSEARCA:STPZ) or the 15+ U.S. TIPS Index fund (LTPZ). The former tries to replicate the performance of the shorter spectrum of the TIPS securities which exhibits lower interest rate sensitivity and therefore should experience a lower volatility. The latter tracks the performance of TIPS with 15 or more years to maturity. All three funds track both the price and yield of the respective securities and have expense ratio of .20%.

The reinvestment risk is present but given the expectations for a steeper yield curve this risk could positively affect the realized total return. If the spread between the short term and long term rates rise, there is a better chance that the coupon payments from currently held treasuries will be reinvested in bonds having the same or a better yield. Hence, such a strategy in the current time could provide at least the expected yield to maturity at the time of purchase which would not be the case if the yield curve was not expected to become a steeper one.

The volatility risk is generally associated with bonds with embedded options whereas the examined Treasuries do not have such options.

The yield curve risk is inherent in the strategy as it depends on a shift in the yield curve to be successful. A long term shift in a negative direction could drive the yields down which could cancel the strategy but also has the potential to drive up the prices of the purchased bonds. Thus the investor would be free to chose whether to stay and rely on the yield or take advantage of any increased bond prices.

Source: Bond Investing Strategy Chasing The Steeper Yield Curve