Prices reset in the global supermarket of bonds:
It is important to recognize the idea that the U.S. bond market is in the latter stages of a 30-year journey during which a “duration tailwind” pushed down market interest rates and boosted returns. This means investors need focus beyond duration, or average maturity, toward other major contributors to returns and sources of value, including positioning on the yield curve, volatility, credit selection and country selection. Keep in mind the fact that the global bond market is $90 trillion in size, which means there are many places to go shopping in what truly is a global supermarket of bonds. Bond investors should walk down each and every aisle of this supermarket, scouring the globe for sources of value that today are more abundant as a result of the recent resetting of market prices.
In aisle one there are U.S. Treasuries, where there is a "breakage," and investors must therefore tread carefully. The Treasury is pure duration risk, or interest rate risk.
In aisle two there are bonds for European peripherals. The breakage there is very messy and it is a very treacherous aisle, so much so that many investors should avoid the aisle entirely.
In aisle three are bonds for core Europe—Germany and France. A contamination of balance sheets for the fiscal and monetary authority have reduced the appeal of this "aisle" relative to other sources of value.
In the rest of the aisles are the other segments of the bond market and bonds from other regions of the globe. These aisle include an array of risk/reward opportunities from senior obligations of high-yield companies, Build America Bonds, bank loans, and the emerging markets. These are aisles investors should walk down to find sources of value.
The dominant theme in the bond market at present is the rise in market interest rates.
Tax initiatives enacted by Washington at the end of 2010 acted as an accelerant to the trend, primarily because market participants were already romancing the notion that the U.S. economy might grow faster than anticipated in 2011.
These pressures are unlikely to abate in the near-term, because economic data are likely to indicate a pickup in growth.
In the context of the tax cuts given by Washington, it is important to keep an emphasis beyond GDP and deficit bean-counting, because the sense among the public—in particular the business community, that government involvement has reached its cyclical peak has positive, albeit indeterminable value. It unleashes something, a something that can be gauged in data on corporate cash, bank reserves, and personal wealth, but whose fullness can only be completely determined by the mood of the nation and the so-called reflexivity--whereby people create their own reality--that is created in markets and the society at large. The rally in risk assets since September is part of this reflexivity. Treasuries are on the losing end of this deal, from the standpoint the improved economic outlook, risk attitudes, and the U.S. fiscal position. Spread products benefit from the deal, because cash flows will likely improve for many companies. Cash flow reduces the risk of default and what a bond investor cares about most is getting his or her money back.
U.S. 10-Year Yields
The U.S. 10-year has moved firmly back into the 3 to 4 percent range it has traded in most of the past three years. One could say that rates are normalizing now that the economy is, and that the range has merely been reset from an abnormally low level that was largely the result of concern about Europe, the risks of deflation, and not necessarily QEII. How do we know this? Consider that rates traded in a 3 to 4 percent range at a time when the Fed had purchased $1.75 trillion of long-term securities.
The trading range for the U.S. 10-year is likely to hold for a while and only when it is clear that U.S. employment growth is strong enough to produce a self-reinforcing virtuous cycle of increases in production, income, and spending will a breach above 4 percent be sustained. The reasons for this are two in particular:
1. Growth that is too slow to result in “escape velocity” (the virtuous cycle) will keep the Federal Reserve sidelined. Low official rates anchor yields along the yield curve.
2. Inflation will stay low so long as employment growth is weak; labor costs account for 70 percent of the inflation process.
The massive increase in Treasury issuance seen over the past few years has had no discernible impact on rates; rates moved lower despite the issuance. I follow an age-old rule on this: Supply only matters in bear markets (for Treasuries). The rule exists because in periods when private credit demands are weak, issuance is more easily absorbed in part because there are fewer alternatives to invest the investable capital. For example, the contraction of the mortgage market means more money is available for investing in Treasuries. Supply therefore will matter if the U.S. economy grows strong enough to both illicit an increase in private credit demands and convince investors that asset classes other than Treasuries are more deserving of their money.
As I mentioned, there are many sources of value in today's bond market. For example, BABs are currently cheap relative to equivalent-maturity corporate bonds and they continue to provide attractive opportunities.
Numerous other sorts of value exist and each is a means of managing the waning of the duration tailwinds. Within each segment of the bond market, whether it is municipal bonds, corporate bonds, loan securities, mortgage-backed securities or emerging market bonds, among others, there is a “safe spread,” which is to say there is a security that is deemed likely to be able to withstand the vicissitudes of a wide range of possible economic scenarios and capable of earning a spread relative to Treasury securities. Bond investing today requires active management, because the passive style of riding the duration tailwind can’t possibly produce the same returns in the next 30 years that were produced in the past 30 years, simply because the scope for decline in market interest rates is now much smaller. There are a lot of choices in the $90 trillion global supermarket of bonds.
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 " and co-author of the 1200-page book "."