The Bond Investor's Dilemma

Includes: BND, HYG, LQD, SHY
by: J.D. Steinhilber

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.