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Talking Points: Is Bond Investing All Uphill From Here?

What Morningstar analysts are hearing about Treasury yields.

Morningstar Analysts, 10/17/2011

The Issues
Spread sectors--industry lingo for just about anything that typically yields more than a Treasury--caught fire shortly after the worst effects of the financial crisis appeared to have cleared the bond market. The rally has had many supports, including a persistent wave of cash flowing into bond mutual funds. The tally for the first half of 2011 registered $92 billion, rounding out a total of $685 billion inflows since December 2008.

The U.S. Federal Reserve has played its part, too, putting a fix on short-term rates at roughly 0.25% over that same stretch since 2008. The Fed has also drained supply from bond markets over that same period via quantitative easing, by purchasing mortgage securities and Treasuries totaling more than $2.3 trillion. Meanwhile, the creation of new securities from the nonagency mortgage securities market has all but come to a standstill, while hundreds of billions of dollars worth of bonds have been taken out of circulation by defaults and refinancings. And while the financial system has pulled back on its overall leverage since the heady precrisis days, the Fed's short-rate policy has encouraged investors to borrow short (for next to nothing) and invest "long"--with every extra bit of yield producing more "free" return.

The net result has been excellent performance for non-Treasury sectors, to the point that their own yields are approaching historically tight levels relative to Treasuries--which many investors worry are already overpriced.

"We can discern a considerable decline in the net supply of a variety of higher-quality fixed-income sectors, particularly those associated with the securitization markets. ... Thus, even with the spike in Treasury bond issuance ... we expect total net fixed income supply to decline after 2010, and to remain well off its 2007 peak."
Rick Rieder
BlackRock Currents, Winter 2011

The Points

  • Rise in Treasury yields will remain bond investors' main worry. Futures markets don't expect a Fed hike before September 2012.
  • Investment managers must decide whether spread sectors offer enough reward to compensate for their risks. Many reputable veterans see continued health, however, even among the two aforementioned aggressive sectors.
  • Spreads have tightened since 2008. U.S. corporate high-yield bonds have been among the strongest performers. They yielded north of 20% at the crisis' nadir but have dropped to 7.1% on average as bond prices have soared. That's a current spread over 10-year Treasury bonds of 400 basis points, or hundredths of a percent, versus 2,000 basis points during the crisis.
  • Emerging-markets debt proved more resilient than U.S. high-yield during the crisis, and their higher yields have gotten more enticing as worries over eurozone and U.S.-government bond markets have mounted. At this point, however, emerging-markets yield spreads over 10-year Treasury bonds have ground down to roughly 250 basis points from around 1,000 in late 2008.
  • High-yield default rates remain at long-term low levels--1.1% over the trailing 12 months, Fitch says. Many issuers have refinanced debt with higher rates or nearer maturities. And while economic growth has been anemic, it has been sufficient to allow corporations to stockpile cash.
  • Several emerging economies boast healthier balance sheets than the U.S. or developed Europe, often boasting half the debt/ GDP ratios. Their higher yields and growth have attracted capital and pushed up currencies.


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