February 15, 2013
Pundits seem infatuated with discussing the bond bubble. Talks of the bubble gained momentum in late 2008 when the 10-year treasury closed at a rate as low as 2.08%. Many investors remember that despite the low treasury rates, other fixed income asset classes such as municipals and corporates presented enticing values. While treasury rates have jumped around over the past four plus years, the 10-year treasury rate continues to hover around 2%. Given inflationary expectations, an investor in treasuries may struggle to keep up with inflation. By understanding what influences bond pricing, and how to identify relative value in the broader market, an astute investor may find a plethora of opportunity in fixed income markets.
Historically, treasury rates have reflected inflationary expectations. However, the activity of the Federal Reserve over the past few years has played a greater role in keeping interest rates low. The front end of the curve is largely influenced by the Federal Funds Rate – the overnight lending rate for banks – which has stayed in a 0 – 0.25% range since December of 2008. The long end of the curve has been influenced by the Federal Reserve’s various quantitative easing programs, which include buying longer treasuries and other fixed income securities in an effort to encourage the housing and employment markets. The Federal Reserve has pledged to maintain these influential programs until unemployment dips below 6.5%, so long as inflation stays below 2.5%. Alamo Capital expects the quantitative easing programs to be relaxed before the Federal Funds Rate increases, which could result in a steepening of the yield curve across all fixed income asset classes. A steepening yield curve could have a more significant impact on the pricing of long-term bonds, in relation to short and medium-term bonds.
Pricing of non-treasury fixed income securities generally reflect a spread from similar maturity treasuries, based on the appropriate discount for risk. As a result, if the yield curve across treasuries steepens, most other fixed income asset classes are likely to follow suit. With the exception of those with very short time horizons, the front end of the curve does not present very much value for many investors. The long end of the curve will generally provide the highest yield, but investors may be subject to diminishing marginal returns – meaning the increase in yield per added unit of duration, may not present sufficient value for some. Alamo Capital is seeing the best value in the yield curve approximately 6 – 12 years out, across tax-free municipals, taxable municipals, corporates, and mortgages. For clients concerned about their portfolios declining in value due to rising interest rates, we are encouraging investments in higher coupon bonds, as they tend to be less sensitive to increases in interest rates.
Predicting the direction of bond pricing continues to be a fluid exercise. If history is an indication, interest rates will inevitably rise from their current levels, though the exact timing and speed of such moves remain uncertain. Long-term investors who over weighted the front end of the curve over the past few years in anticipation of rising interest rates, missed out on one of the greater rallies in municipals, corporates, and mortgages. Alamo Capital encourages building a balanced portfolio across the yield curve which will allow investors to reinvest proceeds in the current interest rate environment, and have some longer term positions to help the portfolio grow over time. As markets constantly evolve, we encourage you to discuss your portfolio with your Alamo Capital Financial Advisor to ensure your investments are optimally working for you.
This report is prepared for informational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument or service. Market prices and other data may be obtained from outside sources and is not warranted as to completeness or accuracy. Any comments, statements and/or recommendations made herein are subject to change without notice, and may not necessarily reflect those of Alamo Capital. Past performance does not guarantee future results. Alamo Capital has no affiliation with any political party. Investing involves risk. Consult with a Financial Professional for additional information to determine the suitability of this or any other financial product or issue as it relates to your particular situation.