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A few days ago, I was asked how I would position the fixed income portion of a portfolio. In order to provide an answer in a timely fashion I basically responded that due to the currently low interest rate environment, a steep yield curve predicting higher rates and corporate credits that would be sensitive to either an improving or weakening economy I would weight the portfolio toward short duration, government debt. Longer duration credits would only be favorable as a means to speculate on falling rates in the short-term or in an economic forecast that gives a high probability to decade with very low inflation. Under any other conditions, long-term bonds are not priced to deliver adequate real returns so a strategy of rolling short-duration bonds should outperform.
While my conclusions remain largely the same I would like to expand on this answer by looking separately at the classes of fixed income securities and exploring a few other options for a fixed income strategy. Fixed income securities include Treasury securities (bills, bonds and TIPS), corporate debt, municipal securities and mortgage back securities (MBS). We will look at each in order and then finish with conclusions and recommendations.
Treasury bills and bonds
Treasury bills are securities with a maturity less than one year and are discount instruments. Bonds have a maturity greater than one year and typically pay a coupon. They may or may not sell at a discount. Treasury instruments are “backed by the full faith and credit of the U.S. government” and are often call “risk-free”. This risk refers to default or credit risk but not interest rate risk. Because of the current lower interest rate environment interest rate risk is a primary concern.
As you can tell from the Figure 2, interest rates have historically moved in long cycles. There was a long cycle from ’53 to ’81 where yields rose from 2.8% to 15.3%. Yields have been in a down trend since the early eighties and the current yield on the 10 year treasury of 3.6% is low compared to the historical example. With interest rates effectively bound by zero there is not a lot of room for further rate compression. The greater risk lies with interest rates surprising to the upside which would push the prices on longer duration credits down. In order to achieve the historical average of a 2.5% real return, the 10 year treasury is implying a better chance of a Japan-like scenario of a decade of minimal inflation than all other scenarios. This weighting seems high over the course of the next decade given the current fiscal policy. Under all other inflation scenarios longer durations credits are likely to disappoint.
Unless your outlook calls for a decade with essentially zero inflation or short-term speculation, the long end of the treasury curve appears less favorable than the short end. As James Montier recently wrote, “It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of Cinderella’s ball as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!””
Treasury Inflation-Protected Securities (TIPS)
TIPS are issued by the US Treasury and provide investors protection from inflation. The principle is adjusted with inflation, as measured by the CPI, and the fixed rate coupon payments are made based on the adjusted principle. In effect both the coupon and the principle are adjusted to reflect inflation.
Currently, the ten year TIP is priced to yield 1.3%. This is below the average real yield since 2003 of 1.8% and well below the cyclical peaks of around 2.5%. If the economy continues to recover and rates rise the real yield on TIPS would be expected to increase, driving down prices.
Although TIPS would be expected to outperform Treasuries if inflation rises much past 2% they are also vulnerable to rising real yields. With the current real yield of 1.3% positioned 28% below the average yield long term TIPS do not appear favorable. Rolling short term instruments should be more favorable until real yields move closer to the historical average.
Corporations issue debt to finance and expand their operations. Typically bonds pay a coupon and are rated by the three main credit rating organizations. AAA is the highest rating with anything below Baa (Moody’s) considered a “junk” bond.
The spread between AAA rated corporate credit and a comparable duration treasury is currently 53 basis points or roughly 33% below the historical average spread. The Baa spread is 147 basis points or 22% below average. See figure 3. If the economy weakens from here spreads would be expected to widen, offsetting some price appreciation from falling yields. In an improving economy – a rising rate environment – spreads may compress further still but aggregate yields would be expected to increase from current low levels.
Based on the narrow yield spreads offered on corporate debt and the relativity low nominal rates, long term corporate debt does not appear to offer above average opportunities at this time.
Municipal Debt (Muni’s)
Muni’s are issued by states and local municipalities and have traditionally been purchased by individual investors seeking tax-free income. Muni’s are typically exempt from Federal income tax and sometime state taxes as well. Because of this feature they have traditionally been utilized by the high net worth investor and other individual investors outside of a tax shielded account like a 401(k) or IRA.
Muni’s have been in the news a lot recently thanks to Meredith Whitney’s forecast that we could see “hundreds of billions of dollars worth of defaults.” This forecast has come under much criticism as it is short on specifics but even still the bond giant PIMCO seems to acknowledge while there are opportunities that exist in the municipal bond space the environment is changing. They conclude that states and municipalities are largely in better fiscal shape than is widely assumed, at least in the short-term, and “we expect defaults will come in far below some of the more pessimistic