Bonds: Strategies for 2010

With the economic recovery appearing to gain momentum, investors may feel more confident about jumping back into stocks than they did in 2009. But looming questions about how the government's withdrawal of its enormous liquidity programs may affect economic growth—and concerns about another shoe dropping in the still-fractured credit market—suggest bonds will remain a key component of investor portfolios in the coming year. David Bogoslaw of Bloomberg BusinessWeek spoke with Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass., on Dec. 23 about opportunities in the bond market in 2010. Are you worried about what rising inflation could mean for returns in existing bond portfolios in 2010? Inflation is determined by rising consumer prices, a loss of consumer purchasing power, and greater availability of credit. Almost 25% of the composition of the Consumer Price Index is rent, and we know that's going to be hindered [by the weak housing market], so consumer prices are not going to be a big part of the picture. Also, wages will be flat because of the weak labor market. Purchasing power is reversing [higher] a little bit with money being taken out of the economy as the government bank bailouts are paid back, but it's hard to forecast because you have to look at other patients in the hospital. The dollar will continue to strengthen if there are problems with other countries' economies and the dollar is viewed as a safe haven again. Availability of credit will also be hindered throughout 2010. The difference in the yield on the 10-year Treasury note and the 10-year Inflation-Protected Securities (TIPS) is about 2.3%. As the bond market sells off, the market is getting ready for the normalization of interest rates, and a normal inflation rate around 2%. The yield curve is starting to steepen. That reflects supply going into the system next year as more Treasury bonds get issued. That means bond yields have to rise to attract enough buyers. Doesn't a steeper yield curve indicate inflation expectations are rising? The yield curve is steepening in response to the Fed saying it will be on hold for an extended period of time. The Fed has an inflation bias. It probably wants to see employment go up before it increases interest rates. The Fed is concerned about housing prices falling again, [which would happen] if interest rates go up too far. Next year is the five-year anniversary of the low-interest-rate environment and the spike in refinancing mortgages with five-year adjustable-rate mortgages. A lot of these people are underwater in their mortgages, so they're locked out of getting a fixed-rate mortgage. There will be sensitivity there and the Fed is aware of this. They have the tools to address rising inflation but they don't have the resources immediately available to deal with a double-dip [recession], because their balance sheet is so stretched. So they need to see clear momentum in the economy before they will raise interest rates. How soon do you expect the Fed to start raising rates? I think the second half of next year will be stronger than the first half, although there's a possibility the economy rebounds faster than anticipated. There will be continued recovery, which we will be able to [monitor with] earnings and economic data. In the second half of 2010, the Fed will have to address the need to come off zero interest rates and will start to tighten [monetary policy]. It's likely to be very passive, to follow the market up as the market demands new returns to compensate for what it thinks the inflation rate will be. What allocation do you suggest for fixed-income bond portfolios for 2010? The theme for 2010 in the bond market is going to be reasonable return. About 60% of portfolio is in that category, 20% in the seeking-yield category, and the balance is inflation protection. That won't benefit [investors until] the tail end of the year, but you need to buy it before you see it happen. If we believe the Fed will be overly aggressive and interest rates will stay down, that means you're forced into the higher-risk part of the marketplace [to get reasonable returns]. I suggest three- to seven-year corporate debt, and things that are less sensitive to rising interest rates such as high-coupon Ginnie Mae (GNMA) [mortgage-backed securities] yielding 6% and 7%. It's probably worth being in some high-yielding sectors, but you have to do it in a liquid form because liquidity could be a problem. So I'm buying high-yield munis, high-yield corporates, and preferred shares in ETFs [exchange-traded funds]. They're my income drivers. They will do very well if the economy recovers, while the reasonable-return assets will do well if the economy muddles through. I'm using the Market Vectors High-Yield Muni ETF (HYD), the SPDR Barclays Capital High Yield Bond (JNK), and the iShares S&P U.S. Preferred Stock Index (PFF). In the high-yield market, spreads are still wide. That gives me a cushion to absorb the strengthening economy much better. What are you using to protect your portfolio from inflation? I'm using four kinds of investment plays. The first is cushion callable bonds. There are a lot of corporates that have high coupons with short maturities, so the bonds will likely be called away [by the issuer if rates stay low]. If inflation rises and they extend, I'll get a high return. Instead of getting a 3.5% yield, you get 4% for six months, but you have to be ready to hold the bond until maturity. If it's not called, I'm getting a reasonable return. One example is Public Service Enterprise Group (PEG). I bought the bonds due January 2013 at a 6% coupon, which are callable in January 2010. I get a 4.5% yield. But the spread to Treasury notes is 4.39%. They probably won't get called at that time but will extend to February or March. If it goes to maturity, it's a 5.96% return. I don't mind that for three years. It's a regulated utility with a BBB credit rating. I'm also using step-up bonds, whose coupon sets higher at a predetermined date over the life of the bond. The Federal Home Loan Bank (FHLB) issued one on Dec. 22. The initial coupon is 4% until January 2015, and then it goes to 4.5% to 5% in January 2016, and to 6% on January 2017. Is there any risk with these bonds if we don't see as strong an economic recovery as people now predict? The problem is if we get a dip, they all get called away and then you have to reinvest in a low-rate environment. [The third inflation-protection instrument] is senior secured bank loans, but in a mutual fund format. I like the Eaton Vance Floating Rate Fund (EABLX), which benefits from rising rates and an improving economy. These loans almost fall in the high-yield category, so I have to watch it to keep tight control on how much I'm willing to lose in this. I always have about a 5% position in this. If you hold it for 90 days, you get to sell it anytime. I want it in a mutual fund so I can liquidate it at the market close if I read of something [concerning] or see something break down in that marketplace. The yield is sort of low at around 3.86%, but it will go up as short-term interest rates rise. The last instrument is WIPs, sovereign debt from countries that all adjust for inflation. The small trading partners of the U.S. tend to have more difficulty in controlling inflation than the the U.S. does. I like TIPS, too, since the fixed coupon part of it acts like a Treasury note if things get ugly, but if inflation rises, it's going to be more market neutral. The problem is it keeps up with the measure of inflation, not market anticipation of inflation, so there's a big lag [before it gains in price].

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