Columbia Management Perspectives: Real Risks and Opportunities in the Bond Market
By Gene Tannuzzo
Portfolio Manager, Strategic income
Portfolio Manager, Strategic income
U.S. Treasury notes have generally offered a yield premium compared to inflation, meaning bond investors could buy Treasury debt and modestly increase their purchasing power. Over the past 50 years, 10-year Treasury notes have offered an average yield more than three percentage points higher than the rate of core PCE inflation, the Federal Reserve’s (Fed) preferred inflation gauge.
Today, monetary policy has altered this long-standing relationship, pushing the yield on the 10-year Treasury note below the rate in core inflation (see chart). Historically, this type of inversion has never persisted for very long, but Ben Bernanke seems determined to change that. In the most recent meeting of the Federal Open Market Committee (FOMC), the Fed reiterated its commitment to keep short term interest rates near zero for an extended period, while also targeting a 2% rate of inflation. This creates a challenge for bond investors. In order to earn a “real” yield, or a yield above the rate of inflation, bond investors need to venture further out on the risk spectrum. This entails increasing duration risk or increasing credit risk. However, with risks abounding in the global economy, caution is warranted.
Globally, storm clouds remain over the euro zone, with Spain and Italy moving to the forefront of concern. Also, economic deceleration in China has raised fears of a broader global slowdown. Meanwhile, the U.S. fiscal cliff of tax increases and spending cuts risks shaving upwards of 5% off of U.S. GDP in 2013, at a time when we are only growing at about 2%. Each of these issues has the potential to generate significant market volatility throughout the remainder of the year. We believe that both interest rate risk and credit risk should be reigned in. We seek to earn an attractive “real” yield in our bond portfolios by investing in high quality companies and countries.
We believe Treasury yields have reached a level at which that asset class is losing its ability to act as a shock absorber in a portfolio. An upside economic surprise could prove damaging to Treasury prices. We prefer high quality corporate bonds and agency Mortgage Backed Securities (MBS) with yields 1%-2% above the rate of inflation and historically wide spreads (risk premiums) that can help cushion the blow of eventually rising Treasury yields.
In the U.S., corporate balance sheets are strong and spreads remain above long-term averages. While the overall economy is only slowly recovering, corporate profits have already surpassed their 2006 pre-recession peak by roughly 20%. However, the corporate deleveraging process is largely behind us, and earnings growth has moderated. We favor investment-grade corporate bonds and senior secured loans. Higher-quality high yield bonds (BB and B rated) remain attractive, but we are avoiding CCC-rated credit and more cyclical industries.
We prefer emerging market sovereigns to developed markets given fundamentals, but both could come under pressure as the U.S. dollar behaves as a safe haven. Despite structural issues in the U.S., the U.S. dollar has risen by over 11% on a trade-weighted basis since its 2011 lows. We remain underweight international markets overall, specifically Japan and the eurozone. Within Emerging Markets, we have a preference toward Latin America and Asia where the growth outlook still leaves room for optimism.
The Fed is telling investors to seek returns beyond U.S. Treasuries, and we agree. But in an environment of elevated risks and depressed yields, investors should seek to avoid tail risk and focus on quality. In our view, the middle of the quality spectrum offers the best opportunity to generate attractive risk-adjusted returns above the rate of inflation.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
Past performance is no guarantee of future results.
© 2012 Columbia Management Investment Advisers, LLC. All rights reserved.
Gene Tannuzzo is a sector manager for strategic income and multisector fixed-income portfolios at Columbia Management Investment Advisers, LLC.