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| > Features > Spotlight |
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| The Game Is Up |
| by
Miriam Sjoblom
| 06-01-10 |
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"The game is rigged, but you cannot lose if you do not play."
--Marla Daniels, "The Wire"
In the HBO drama "The Wire," Marla Daniels was talking about city politics, but her advice could be applied to today's fixed-income markets. Bond investors, take heed: The game looks rigged.
Owners of bonds get their returns from two places: income and price appreciation (or depreciation). In light of the low level of current yields across bond sectors and the threat of higher rates to come, neither factor gives investors cause for optimism.
Now that 2009's record-breaking bargains are gone, bond fund managers' jobs have gotten a lot tougher. The same risks that roiled markets in the past decade won't necessarily dominate in the one ahead, and it's more important than ever to understand the compromises and trade-offs bond managers now must make. Otherwise, in this game, you and your clients won't have a sporting chance.
An Income Shortage
Let's start with income. After 2009's rebound among nongovernment bonds, yields across bond sectors now hover near their all-time lows. The 3.5% yield on the Barclays Capital Aggregate Bond Index, a common benchmark for many domestic investment-grade bond funds, is as low as it's been in its nearly four-decade history. To put that into context, the index yielded anywhere from 7% to 10% for much of the 1970s. It then climbed as high as 15% in 1981 but dropped below 9% by the end of that decade. During the 1990s, it fluctuated between 5% and 9%.
So, from an income standpoint, bond investors are hobbled. Even if yields stay where they are for the time being and investors in index-hugging taxable-bond funds are able to collect their 3.5% return from clipping bond coupons, that's still a far cry from the 6% annualized return delivered by Vanguard Total Bond Market Index VBMFX during the past decade, or its 7.5% annualized gain in the 1990s. Actively managed bond funds with high-quality mandates aren't in much better shape. After 2009's rebound, the additional yield offered by some bond sectors has narrowed considerably. For example, the average yield spread on investment-grade corporate bonds has narrowed to less than 150 basis points today from 600 basis points in late 2008. (The highest-quality corporates now offer a slim 50 basis points over Treasuries.) As a result, the average absolute yield on investment-grade corporates has dropped below 4.5%.
Many managers have often relied on agency mortgage-backed securities--those issued by Fannie Mae, Freddie Mac, or Ginnie Mae--for extra income, but they're finding that to be more difficult today. The Federal Reserve's gradual purchase of $1.25 trillion in agency mortgages (it finished buying in March) has driven prices up and yields down to the point where many managers argue they've rarely looked more expensive. Government programs such as the Term Asset-Backed Loan Facility and the Public-Private Investment Partnership have had their intended effect of restoring liquidity to the nongovernment securitized bond market, but they've also raised valuations in the asset-backed and commercial mortgage-backed securities sectors. Meanwhile, the private securitization of commercial and residential mortgages has not revived, and that lack of supply is another factor pushing yields lower.
A Threat on the Horizon
If a paltry income stream isn't enough to get you rattled, perhaps the threat of higher yields will. That's not to say a huge spike in interest rates is imminent. The broad market consensus expects the Federal Reserve to keep its target short-term rate near zero for several more months, if not through the rest of 2010. Ben Bernanke's Fed has also gone to considerable lengths to remove the element of surprise from its playbook, and it's considered gospel that the Fed will alter its "exceptionally low for an extended period" language well in advance of any actual tightening. There's some uncertainty about how the market might react to that signal alone, of course. As PIMCO's cash guru, Paul McCulley, stated earlier this year, "The most important book at the Fed right now is a thesaurus."
Shorter borrowing rates often move in lock step with the Fed's moves, but longer-term Treasury yields can have minds of their own. The market's confidence in the Fed's ability to keep inflation under wraps matters a lot. Many observers agree that still-large output gaps and high unemployment should keep inflation muted in the near term. The Fed also has many more tools at its disposal today to combat inflation--including hiking its target rate, draining bank reserves, and selling bonds--than it has to fight deflation, and investors know it.
Simple supply-and-demand dynamics also play a role, and on that front, the case for lower- for-longer Treasury yields weakens. Although the final amount depends on the speed and magnitude of an economic recovery, many analysts predict that the Treasury will have to issue more than $2 trillion in debt by the end of 2010 ($1.9 trillion was issued in 2009). The Treasury has also announced its intention to shift new issuance away from short-term T-bills into longer-term notes and bonds, which could apply upward pressure on longer maturity yields. Regardless of the economy's near-term fortunes, the mounting entitlements of Medicare and Social Security, coupled with an aging U.S. population, argue loudest for more Treasury issuance and higher yields in coming years.
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