March 2006
We turned bearish towards bonds back in June of 2003 when the yield on the 10-year U.S. Treasury note fell to just above 3%. After all, who would want to invest in a 10-year bond with such as paltry yield of 3.1%? Now after three years, with interest rates on a steady and upward trajectory, we think we are nearing the end of that part of the cycle. To take advantage of these higher interest rates, we will soon begin to buy longer maturity bonds before the rates head back down later this year or next.
Bonds really are an essential part of a long-term investment program especially for people near or in retirement who simply cannot afford to lose much or even stomach downturns. Unfortunately, bonds are often underappreciated and misunderstood. They are labeled "boring" by investors who want the chance to earn much bigger returns from more exciting (read, volatile) investments. Also, because of the silent and steady erosion of inflation, they have had the reputation of being a confiscator of wealth over time.
The reasons for having bonds in a portfolio are simple. They provide a dependable source of income and they work to protect a portion of the portfolio from a substantial decline in value. Obviously, investors learn to appreciate bonds just after the stock market takes a bad fall like it did only a few years ago. After something like that, boring bonds start to look pretty exciting!
Managing bonds in a portfolio is a balancing act. We're trying to maximize the income earned but at the same time we're trying protecting the real value of the money invested from not only the obvious risk of default but also from the damaging effects of rising interest rates and inflation.
Bond prices fall when interest rates rise and their prices rise when interest rates fall. Think of this as a kind of "teeter-totter of finance" with price sitting just opposite of interest rates. Also, the longer the maturity of the bond the more the price fluctuates when interest rates go up and down. The farther out the board you sit, the more exciting the ride.
Therefore, when interest rates are rising, it is wise to keep the maturities of bonds relatively short to limit the declines in the prices of the bonds. After rates are done going up, it's very nice to have bonds that are easy to sell at close to full value or to even have them simply mature. In this way, the proceeds can be reinvested in higher yielding securities to increase the income of the portfolio.
About three years ago, we reduced the average maturities of our clients' fixed income portfolios as a defensive measure because we believed the downward trend in interest rates was over. We thought the risks were high that interest rates would be rising as the economy improved. In fact, that turned out to be the case.
The Federal Reserve has since increased short-term interest rates by 3 1/2 percentage points from 1% to 4.5% since June of 2004 in its effort to get those rates to a more normal or neutral level. That rate could go to 5% in the next few months.
The 10-year U.S. Treasury note yield rose from a low of 3.1% in 2003 to around 4.7% today. It could easily close in on 5% if Japan or China reduces their appetite for our bonds or if inflation creeps a little higher.
In a normal world, longer-term bond yields are usually higher than shorter-term bond rates. This is to compensate investors for the risk of inflation and simply having to wait longer to get their money back. However, right now the yield on a 2-year Treasury note is slightly higher than the yield on a 10-year note. This is known as the dreaded "inverted yield curve". There is a strong possibility that short-term rates could rise even farther above the longer-term rates by this summer.
It's certainly fair to ask why we would even think about risking our clients' money in longer dated securities when the yield is less. The answer is we feel the need to address another risk in bond portfolios that is often forgotten; reinvestment risk.
Reinvestment risk is the possibility of having to reinvest the proceeds of a maturing CD or bond when interest rates are lower. Over the past two decades as interest rates have steadily fallen, reinvestment has been a very common problem for bond investors. We think the reinvestment risk in the bond market is rising today.
History has shown that inverted yield curves normally last anywhere from two months to almost a year. The average duration is a little over six months. This recent inversion started about three months ago. It most likely will last at least a few more months as the Fed keeps raising rates in the face of a seemingly strong economy and as their worries about inflation keep building.
In managing bond portfolios through an interest rate cycle there are two very difficult decisions to make that guarantee that the portfolio will immediately earn less income now in return for the hope of earning more income later.
The first one is to sell higher yielding long-term bonds to purchase lower yielding short-term bonds in an effort to protect the portfolio against the detrimental effects of a possible rise in interest rates. That strategy did not work very well over the last three years despite the historical precedents that it would.
The second tough decision is to sell a higher yielding short-term bond and then turn right around and invest in a lower yielding longer-term bond. Again, you're choosing to give up some income now just to be able to lock-in that income for longer. Investors obviously do this to avoid the ugly possibility that they will ride interest rates down and earn less and less income during trip downward. This is where we find ourselves today.
While the economy did bounce back in the first quarter of this year from a slowdown in the fourth quarter of last year, we think we will see a steady slowdown as the year moves on. With that as a backdrop, we'll soon begin to hear the talk of lower interest rates in the future.
Nonetheless, even if we are a bit early with our reinvestment risk worry, the process of restructuring a bond portfolio does take some time to fully execute. The first move is to simply take the proceeds from bonds that are maturing in the months to come and begin to slowly move farther out. Yes, we mean further out yield curve not the teeter-totter!
John W. Gudritz, CFA
john@frontstreet.com