Permanent Value

Week in Review 12/9/13

Bruce Doole
December 9th, 2013

Judging by trends in U.S. fixed income funds, it would seem that many investors have growing concerns about future price declines; we believe that risk is substantially lower now. Evidence abounds that individuals have been selling duration and bond market risk, including outflows from long-term bond funds, sales of municipal bonds and bond funds, redemption of fixed income ETF shares, and sharply larger discounts on closed-end bond funds. We think a rational investor, with appropriate portfolio weights entering a period of higher interest rates, would be adding to fixed income allocations, especially given some of the discounts on offer. Perhaps the explanation is that many investors discovered their bond allocations
and duration exposure were too high and have finally taken steps to reduce their portfolio weights.

Overreaction by uncomfortable investors has left pockets of opportunities in some market segments, although admittedly not those primarily inhabited by institutional investors. Closed-end bond funds, municipal bonds, and TIPS (U.S. government inflation-linked securities) are available at attractive valuations relative to the broader market. There is evidence of significant retail selling in emerging market bonds as well.

Even the broader bond market has become more attractive, or at least significantly less unattractive, in the recent past. For example, one may not realize that as ten-year Treasury yields were climbing 1.3% from late April through early September, forward real yields (implied from U.S. inflation securities) rose by as much as 2.2%. At 1.6% to 1.8%, forward real yields in the five- to seven-year segment of the Treasury curve actually looked good from a long-term perspective. Contrast these real yields with cash (-2.0%) or the five-year TIPS (-0.7%).

Since September these forward real yields have fallen by 50 to 70 basis points, but the recovery to normal real yields is well under way. Interest rates in the first several years of the curve are still pinned low by the FOMC and have plenty of room to rise. Farther out, forward real rates are perhaps two-thirds of the way back to normal from the extraordinarily low levels of late 2012, and only a modicum of favorable economic data could push them all the way back to normal.

The Federal Reserve seems eager to reduce its bond purchases. Perhaps it will be able to “strengthen” its forward guidance to guard against further over-reactions, but it is quite possible that additional allocation out of bonds will push the general market to attractive levels. After all, as the FOMC ceases its buying program, yields must be high enough to induce other buyers to clear the market. As this process evolves, there should continue to be excellent opportunities to buy cheap fixed income exposure, either in pockets (as now) or in broad segments of the curve should rates spike higher.


Source: Amundi Smith Breeden