Bond Market Reaches a Crossroad. Here's What to Do.

It no longer shares the stock market’s enthusiasm.

Bond market at a crossroads.

Photographer: Krisztian Bocsi

The bond market is at a crossroads. The charts are signaling that the 2.32 percent yield on the benchmark 10-year Treasury note marks a major line of support/resistance. The bond mavens just can’t quite seem to decide where we are now heading now. In my view, it all depends on what you are looking at these days.

Last month, when the yield was hovering around 2.60 percent, it seemed as if every Tom, Dick and Harry -- with a very few exceptions, including me -- was calling for a 3 percent yield by now. Well, that didn’t happen, and now I sense a good deal of confusion at many major money managers. President Donald Trump is extolling huge tax cuts and equities have skyrocketed as a result, but the bond markets have decoupled from the stock market’s enthusiasm. We seem to have arrived at the dreaded “very difficult moment.”

If we break the 2.32 percent line on the upside, then we are likely back to the 2.32 percent to 2.51 percent range that the market has stuck in since late November. If the market holds here, the yield could be headed back down to 2 percent.

So, what’s it going to be? To answer that, you need to first identify the problem. But that is only the start. Problems without solutions are a venture into a no man’s land called “guessing” and that is a place to be avoided at all cost. “I never guess. It is a shocking habit, destructive to the logical faculty” -- Sherlock Holmes

My answer is step-up bonds, which have coupons that rise over time. Depending upon your risk appetite you can buy Agency ones or corporate ones, and both address the issue of “interest-rate protection.” Current yield spreads for those issued by the Federal National Mortgage Association or the Federal Home Loan Mortgage Corp. suggest holders aren’t being paid for structural risks. The wide variety in terms of structure and maturities issued by the Federal Home Loan Bank system are more reasonable.

The derivative is built into the structure and it is not your derivative but the FHLB’s derivative, and one for which you have no responsibility. That means if yields go down, they can get called just like a normal callable Agency, but if yields rise and they are not called, then the coupon steps to a higher rate, providing the holder with both yield protection and, ostensibly, a higher mark-to-market when your portfolio is evaluated.

The step-up option is far more desirable, at present, than either non-callable bonds or Agency callable bonds. It’s best to take the risk protection, bond insurance if you will, at a time when the event risk scenario is quite high in Europe, North Korea rages, and a current disconnect exists between Trump’s ambitions and his accomplishments. I am not being negative, but rather cautious with possibility of France exiting the European Union -- a “Frexit” -- still on the horizon, the Italian banks in disarray, and Greece unlikely to get funding from the International Monetary Fund. Insurance exists for a reason.

I am also getting quite concerned about the equity markets. The S&P 500 Index is up some 11 percent since the U.S. elections. Regardless of the ever-loftier valuations and loftier banter in the financial press, this is not going to go on much longer. We are passing into Alan Greenspan’s “Irrational Exuberance” land of make-believe, once again. “I suppose it’s like the ticking crocodile, isn’t it? Time is chasing after all of us” -- J.M. Barrie, Peter Pan.

On Nov. 8 and 9 I called for buying equities, and I am now changing my position. There is very little room to run from here, and I would be taking some profits and thanking the gods of the marketplace for them. I now prefer my “Cash Flow Investing Strategy” where corporate bonds and closed-end bond funds are used, in tandem, to produce yields of 7 percent to 7.50 percent.

The yields are locked in at inception, and while credit issues are always present and the sponsors can change the monthly pay-outs on the closed-end bond funds, the risk factor is far less than equities now. You have to know what you are doing and I utilize very specific strategies for both the bonds and the funds, but I am quite happy to receive 500 basis points and more over the 10-year Treasury in what I believe is a very conservative manner to produce income. The monthly income is also quite useful, if you don’t need the cash, for adjusting to the markets, whatever they may hold in store.

Here is one more type of insurance. “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful” -- Warren Buffett. Take your pick.

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