A Spoonful Of Sugar...To Support The Fed's Taper

by: Jeffrey Rosenberg

Yesterday, the Federal Reserve announced a reduction in its bond buying program known as quantitative easing (QE). While bond markets barely budged, stock markets rallied strongly following the announcement. The step back signals the Fed's confidence that the economy is on firmer footing, while at the same time reinforcing its goals to keep monetary policy - in the form of zero interest rates - low for longer. Despite yesterday's good result, going forward such a transition may still be rocky for financial markets.

The specifics of the plan are here, but the headline is a $10 billion / month reduction in purchases of Treasury bonds and mortgage-backed securities.

What does this mean?

  1. Not a big shock. This won't be a big shock for bonds, because there's still plenty of "easy money" in the global financial system as the Fed promised again today. That's not to say interest rates won't move higher over time. We are looking for the 10-year U.S. Treasury to end the year higher by around 50 basis points (0.5%) on the back of stronger growth next year.
  2. Low for Longer. It's important to note that while the bond-buying program will be slowed, to avoid negative economic consequences of a sharp rise in rates, the Fed will likely keep the short-term fed funds rate low for an extended time. This is the "sugar" in the Fed's communications.
  3. Inflation should remain muted. Given the continued slow growth nature of the recovery, inflation, now at a four-year low in the United States, is likely to stay low at least through 2014 though we expect some modest increases next year.

What does this mean for bond investors? We would suggest:

  1. Shift out of traditional bonds. Traditional bonds could experience losses. Traditional bond funds as in those found in the Morningstar Intermediate Bond Category still carry too much duration risk such that a 0.5% rise in rates could mean a 2.5% loss in principal effectively negating any income gains.
  2. Inflation protection is expensive. Since the rate of inflation is near flat, bonds designed to protect against loss of value to inflation, such as Treasury Inflation Protected Securities (TIPS), are not worth owning. But longer maturity TIPS recent re-pricing makes that area of fixed income attractive. Consider more flexible allocations that can differentiate investments across the maturity spectrum.
  3. Focus on credit. Bonds that trade based on credit, or the ability of the issuer to pay back its obligations, can diversify a portfolio from the risks of rising interest rates. While not inexpensive, credit spread sectors - high yield, commercial mortgages and other asset-backed bonds as well as longer-dated municipal bonds - are all still better bets than Treasuries.

Original Post

The opinions expressed are those of Jeffrey Rosenberg as of 12/18/13 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of any individual holdings or market sectors.

Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies.