How to Trade a Familiar and Frustrating Fixed Income Market
For all but the contrarians, uncertainty over a deficit-reduction deal and the economic recovery, combined with certainty about the Fed's liquidity efforts, will make the fixed-income market a familiar place in the year following a national election that preserved the status quo in Washington.
U.S. Treasurys, high quality corporate bonds and to a lesser extent select high-yield bonds are the investments of choice, even if their already unattractive — and in some cases unprofitable — yields budge a little bit in either direction, analysts say.
"What you see is what you get," said James Awad, managing director at Zephyr Management. "Slow growth, regardless of who's president; low inflation, for the time being; in Europe, a modest contraction; in emerging markets, a bottoming in the de-acceleration of growth; the U.S. deficit kicked down the road with maybe a modest package — some tax hikes, some spending cuts; and the Fed's liquidity. None of that will change the character of the fixed income market."
Not that those circumstances make fixed income investing any less challenging than it has been in the past two years, when interest rates defied almost everyone's expectations, hitting new lows.
"This is a very difficult environment because of the low rates and the potential risks," said Howard Kaplan, a financial planner in Tenafly, N.J. "When is safe money going to get some payment? I don't think anyone has the answer."
For contrarians such as Ram Bhagavatula, managing director of the hedge fund Combinatorics Capital, the interest rate equation is about to change. He believes the cyclical economic recovery will become the driver of the fixed income market — not the fiscal cliff, when automatic tax hikes and spending cuts are set to kick in on Jan. 1.
"The bear market in fixed income is here," he said. "The last piece of the puzzle — housing — is turning around. Loan demand is picking up. The temporary [economic] slowdown is done. Interest rates are too low given all the economic indicators."
Strategies: What and Why
So what's a retail investor to do? We asked strategists, money managers and financial planners to share their outlook and investment choices.
Bulls or bears, all of them say the short end of the market is where to be. But some also like aspects of the long end.
For Bhagavatula, it's the front end of the market because investors can afford to hold their Treasurys until maturity while not losing any principal. "Recovery risks and inflation risks show up first in the long end," he said.
For Awad, the "sweetest" time frame is bonds of two to five years.
For Lon Erickson, portfolio manager of fixed income at Thornburg Investment Management, it's three to seven years.
For Scott Kimball, a portfolio manager with Taplin, Canida & Habacht, it's three-year high yield debt, along with investment-grade corporate bonds.
Differences in strategy, however, emerge in allocation, with some portfolios more diverse than others.
Kimball's barbell approach is based on the assumptions that "the GDP concern, the growth concern, is going to drive the bond market in 2013" and that "political gridlock is going to be one of the banes of the market."
His firm's fixed income portfolio involves being overweight in long Treasurys and high-quality industrial commercial paper, along with some long-maturity Treasury Inflation Protected Securities (TIPS), for the sake of inflation risk.
"You could see longer-term rates come down," Kimball said.
Kimball said the firm uses corporate bonds for shorter-duration assets.
Finally, "high yield is where we take out credit bets," he said, noting that it is possible to find three-year bonds that yield 300 to 400 basis points more than short-term Treasury notes.
For Erickson, economic uncertainty is a factor, but he believes the market will ultimately be driven "by how the fiscal side is taken care of."
Any budget deal will help the economy, he said.
Thornburg's core bond fund is based on a "10-year layered strategy that is heavily invested in corporate debt," he said. It is heavy-weighted with industrial companies but includes select foreign ones.
As for junk bonds, he said the market "is pretty rich, although there are still some opportunities."
Erikson and others noted that the European Union debt crisis is still a factor, pointing to the latest flare-up Wednesday, when European Central Bank President Mario Draghi said "developments are now starting to affect the German economy."
"If this is the start of a weakening cycle in Germany, people will still come to the Treasurys no matter how ugly the yields are," Erikson said. "It's still the safest place to invest."
Kimball agreed, saying "Treasurys are still the safe haven." He said debt-to-GDP ratios in Europe were worsening because austerity measures were hurting economies, such that growth was slowing faster than debt levels.
Awad prefers corporate bonds to Treasurys, believing interest rates probably bottomed in July.
He specifically recommended the bonds of financial firms, naming Goldman Sachs
nd Jefferies Group s examples, which can pay as high as 4 percent, significantly more than companies in other sectors. Retail investors can get in with a $10,000 investment.
Awad said the premium reflects the financial crisis of 2008-2009 and its aftermath, which included tighter regulation and reduced profitability.
There are people who think we can have another accident," he said. "It's a good risk reward [equation]."
For Kaplan, the strategy is "looking for alternatives to the typical fixed income balance sheet," which may appear exotic to the average retail investor.
As an example, he mentioned Franklin Square Capital Partners, which has launched three non-traded business development companies whose investment focus is the debt of privately held U.S. companies.
"If rates go up, you won't be affected negatively," he said.
Its first fund, now closed, paid a 7-plus percent dividend. A similar one is still open to investors. he minimum investment is $4,000.
"It's sort of like a non-traded REIT (Real Estate Investment Trust) but it is more transparent," he said.
Kaplan and most of the other investing pros are relatively negative on municipal bonds, citing uncertainty about the economy and tax policy — at least for now.
In the current environment, with the overall economy and local tax bases still on the mend, munis are riskier than the alternatives.
In addition, there's speculation that their tax-deferred treatment will be reduced, which would lower returns.
There's a chance, however, that things could swing the right way for munis. The same tax uncertainty could end with increases in other areas – ordinary income, capital gains, dividends – making muni tax advantages worth more to their core investor, high-income earners.
Positive change in the economy could also make them less risky and more rewarding.
"If the economy improves, municipal credit quality improves because tax revenue improves," said Bhagavatula of Combinatorics. "The broad interest effect will push yields higher."
Higher, however, remains the less likely direction for most analysts. There's no existing force at this point to outweigh the Fed's commitment to low interest rates and the inevitable political squabbling and potential tumult of budget-deficit talks.
"There's so much uncertainty," said Erickson, who sees little change over the next 12-18 months.
One thing is certain, though: "Our message to investors is that rates will rise again -- be prepared."