Shopping the global supermarket of bonds
By Tony Crescenzi, an executive vice-president, market strategist and portfolio manager at PIMCO. The opinions expressed are his own.
It is important to recognize the idea that the U.S. bond market is in the latter stages of a 30-year journey during which a “duration tailwind” pushed down market interest rates and boosted returns. This means investors need focus beyond duration, or average maturity, toward other major contributors to returns and sources of value, including positioning on the yield curve, volatility, credit selection and country selection. Keep in mind the fact that the global bond market is $90 trillion in size, which means there are many places to go shopping in what truly is a global supermarket of bonds. Bond investors should walk down each and every aisle of this supermarket, scouring the globe for sources of value, recognizing that there are many different types of bonds to suit a variety of economic and financial conditions.
Outlook for the Fixed-Income Markets
The simple “Twitter” line on fixed-income strategy for 2011 is that we at PIMCO prefer credit risk over interest rate risk, which is to say we believe economic growth in the U.S. of 3.0 to 3.5 percent in 2011 will boost cash flows to U.S. companies and thereby reduce default risks, warranting, at current valuations, this strategy.
Think of the bond market and the current situation in terms of a global bond supermarket. In aisle one are U.S. Treasuries, where there is a “breakage,” and investors must therefore tread carefully. The Treasury is pure duration risk, or interest rate risk and this risk should be avoided when economic conditions are strengthening, real interest rates are abnormally low, and inflation is accelerating. The Treasury market’s main anchors are the low inflation rate and the near-zero federal funds rate. The former is already moving upward and the latter eventually will.
In aisle two there are bonds for European peripherals. The breakage there is very messy and it is a very treacherous aisle, so much so that many investors should avoid the aisle entirely.
In the rest of the aisles are the other segments of the bond market and bonds from other regions of the globe. These aisles include an array of risk/reward opportunities including senior obligations of high-yield companies, Build America Bonds, bank loans, and the emerging markets. These are aisles investors should walk down to find sources of value. If the yield spreads between these securities and Treasuries narrows, investors that switched from Treasuries to these instruments benefit not only from having offset the increase in market interest rates (in whole or in part), but they will have earned a higher rate of return on their money. This is one way investors combat a rising interest rate environment. Floating-rate securities also provide protection, because their yields increase if the rates they are tied to (typically LIBOR) rise.
U.S. 10-Year Yields
The U.S. 10-year has moved firmly back into the 3 to 4 percent range it has traded in most of the past three years. One could say that rates are normalizing now that the economy is, and that the range has merely been reset from an abnormally low level.
The trading range for the U.S. 10-year is likely to hold for a while and only when it is clear that U.S. employment growth is strong enough to produce a self-reinforcing virtuous cycle of increases in production, income and spending. Expect the 10-year’s yield to spend most of its time in the upper half of its 3 to 4 percent range until that time. Eventually, when the bond markets anchors are raised—when inflation accelerates and when in particular the Fed raises rates, a move above 4 percent will become possible. We do not see the Fed raising interest rates this year.
Go Shopping in the Global Bond Supermarket
Numerous sorts of value exist in the bond market and each is a means of managing the waning of the duration tailwind. Within each segment of the bond market, whether it is municipal bonds, corporate bonds, loan securities, mortgage-backed securities or emerging market bonds, among others, there is a “safe spread,” which is to say there is a security that is deemed likely to be able to withstand the vicissitudes of a wide range of possible economic scenarios and capable of earning a spread relative to Treasury securities. Bond investing today requires active management, because the passive style of riding the duration tailwind can’t possibly produce the same returns in the next 30 years that were produced in the past 30 years, simply because the scope for decline in market interest rates is now much smaller. There are a lot of choices in the $90 trillion global supermarket of bonds.