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Crescenzi: The Market of Bonds


In the U.S. and in much of the developed world, there are powerful cyclical tailwinds and secular headwinds that investors must consider when constructing their investment portfolios.

These powerful winds leave bond investors not knowing which way to lean.

The answer is they should heed both the cyclical tailwinds and the secular headwinds because the influence of each is so strong. Investors are therefore behooved to ride the cyclical tailwinds and invest in securities that have a tendency to do well in cyclical upturns, and to heed the secular influences that pose risks across the investment landscape, both today and in the future.

More than ever, the bond market has therefore become a market of bonds. This is in sharp contrast to early 2009 when the investment of choice was to load up on anything with a yield spread to Treasuries and bet on fairly uniform movement on many fronts including the direction of yields, the shape of the yield curve, and on global policy rates. Today’s investment landscape is much different, requiring bond investors formulate strategies that more carefully consider the very different attributes of the bonds they are buying.

Corporate Bonds

The corporate bond market consists of bonds with very different attributes.

This means that it is a market of bonds most of the times, especially now that corporate bond yields have moved sharply lower relative to U.S. Treasuries.

In other words, investors aren’t being rewarded as much for the risks they take than was the case a year ago, when investors moved out the risk spectrum following actions taken by the Federal Reserve to underpin the value of financial assets. With risk premiums having fallen compared to a year ago, investors therefore must more carefully consider the risk attributes of the corporate bonds they buy. This is a big task, because no two corporate bonds are alike; some can be redeemed early, some are a hybrid of equities and bonds, and they emanate from many different sectors of the economy, making it important to differentiate between industries that will benefit from the cyclical advance from those at risk from secular influences.

Secular risks to the U.S. economy make it important to choose high-quality bonds as well as those that tend to have high recovery rates and dependable revenue streams. PIMCO Managing Director Mark Kiesel has written at length about this, and he has also spoken to the idea that there are a number of risks facing the corporate bond market; for example, he says investors “need to be wary of the pendulum swinging from bondholders toward equity holders” with companies directing cash toward dividends and stock buybacks.

Municipal Bonds

The municipal bond market is also a market of bonds.

Secular headwinds make it more important to consider municipal bonds with dependable income streams. Revenue bonds, which are bonds backed by revenues such as highway tolls, are an example. Historically, revenue bonds have been influenced more by cyclical influences than have general obligation (GO) bonds, because revenues fluctuate. GO bonds, on the other hand, rely upon the general taxing power of the municipality. This taxing power is not in question, but investors must question whether municipalities will have enough money left over to get repaid. Investors could instead choose revenue bonds with reliable and dedicated income streams. These include essential-purpose bonds with revenues tied to water, sewer, and energy use, and airports.

The Yield Curve

Whereas in 2009 betting on a steep yield curve was the best bet, the competing cyclical and secular influences make today’s bet bifurcated. For example, if torque does in fact lead to job growth, the coupon curve (2 years maturity and beyond) will likely flatten—it typically peaks with the peak in the unemployment rate. On the other hand, the money market will be slower to react and not move substantially until the eve of Fed rate hikes.

Global Bonds

The market of bonds idea broadens when the global bond market is considered. Investors must be mindful of the secular headwinds that will influence not only the countries they select, but the selections they make within these countries, similar to what they must do in the U.S. The top secular influence here is sovereign, or government credit risk. Investors that have lived in a benchmark-centric world and tailored the construction of their bond portfolios to that of major bond indexes will increasingly look away from their benchmarks, favoring countries with better debt dynamics and prospects for economic growth.

There are many other segments of the bond market that I have not covered that will surely see their own market of bonds. For example, the mortgage-backed securities market will be affected by not only the many cyclical influences now in play, but the secular ones, not the least of which is the Federal Reserve now both a referee and player, having purchased $1.25 trillion of mortgage-backed securities over the past year and a half.

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Tony Crescenzi

Tony Crescenzi is Senior VP, Strategist, Portfolio Manager Pimco. Crescenzi makes regular appearances on financial television stations such as CNBC and Bloomberg, and is frequently quoted across the news media. He is also the author of "Investing from the Top Down," "The Strategic Bond Investor," and co-author of the 1200-page book "The Money Market."