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Opportunities In Out-of-Favor Bonds

100sharesI wanted to share this great article I came across in Fidelity Viewpoints from November 2nd with you. I think you will find the article very timely.

Opportunities in out-of-favor bonds

FIDELITY VIEWPOINTS — 11/02/11

Consider corporate bonds and Treasury Inflation-Protected Securities (TIPS).

When volatility rises and the economic outlook weakens, Treasuries tend to gain. That’s the climate we’re in now, according to a panel of Fidelity experts. And it’s likely to remain so for several months at least, with Europe debt troubles still unresolved, rising concerns about the sustainability of China’s growth, the potential for significant budget cuts from the Congressional Super Committee, and a U.S. economy that keeps flirting with recession.

But these negatives have produced potential opportunities. Our bond experts say that they are starting to look at out-of-favor issues that may benefit if the dour fiscal and economic sentiment starts to improve.

Many of you will be preparing for Thanksgiving dinner, battling traffic at the airports to visit family, or gearing up for the pro football games the next day. But this date is also the time when the U.S. government potentially could be downgraded by two rating agencies, Fitch and Moody’s.

The Congressional joint committee on deficit reduction (the Super Committee) is due to release its proposal on November 23. This bipartisan committee is perhaps one of the most powerful committees to have been set up in the United States over the last century—except during war time. Its recommendations will be subject to a simple majority up-or-down vote on December 23. If the package of recommendations is voted down, the government will be subject to automatic spending cuts effective in 2013.

The panel has a lot of options. It could recommend cutting corporate taxes, dividends, or tax rates for the repatriation of profits earned overseas. It could include components designed to create jobs, including pieces of the recently proposed plan by the president. The committee could even vote to set up an infrastructure bank, or slip in sanctions against countries it perceives to be controlling their currency, including China.

In short, this committee can do many things that could have a direct impact on investors in stocks and bonds, which is why I stress that you put the date on your calendar. The potential for financial market reaction that week—and potentially ahead of that date as leaks emerge from Washington—could result in increased volatility and risk aversion. Given that markets will be thin during the holiday already, large price swings are possible.

Perhaps more concerning is the reaction from the remaining two rating agencies that currently give the United States a triple-A rating.1 If the recommendations by the committee do not achieve significant savings or revenues, or if the committee ends in a deadlock, Moody’s and Fitch could reduce their rating also. As investors recall, the financial markets—particularly stocks—faced very large volatility and declines following the downgrade from triple A to AA+ by Standard & Poor’s this summer.

Now, perhaps because I am an optimist, I think the committee could surprise markets with a slightly larger than expected set of recommendations—perhaps on the order of $2 trillion. Why? Because of the attention Americans across the country are paying to our fiscal situation; the composition of the committee, which includes several fiscally motivated individuals; and the significant focus on the sovereign debt situation in Europe. Hopefully, these factors will motivate some sort of plan that impresses investors and the rating agencies, and perhaps boosts investor sentiment and asset prices.

But the panel isn’t the end game. The 2012 Congressional and Presidential elections will focus on fiscal policy. I believe that whoever wins these seats in Congress and the Presidency will realize that the current and looming fiscal issues should be one of the first things they address. As a result, the chances increase that some rather dramatic policy initiatives may be enacted in the first three to four months of 2013.

So, enjoy Thanksgiving, but be aware that the surrounding days and weeks could be fraught with volatility—but also could offer potential opportunities in stock and bond markets.

So let’s get right to the elephant in the room. Treasury yields are low—very low. Despite the consumer price inflation currently running at a 3.9% annual rate, interest rates on short Treasury bills are effectively zero, and the 10-year Treasury note yield is approximately 2%, a six-decade low as of November 1, 2011.

So why do investors keep buying bonds and bond funds when the entire U.S. yield curve is well below inflation? I see three big reasons: Call them the three Ds.

1. Double dip

Many investors are much more concerned about the U.S. economy going back into recession than they are about runaway inflation, and that has led them to favor bonds rather than more risky assets like stocks. My view, however, is that we will muddle through at 1% to 2% real GDP growth. Not impressive, but above zero. This means that interest rates could rise from today’s levels, but probably not dramatically.

2. Deflation

With economic activity stagnant at best, investors believe that today’s elevated inflation is unlikely to persist. One of the main reasons for this is the continued deleveraging of the U.S. economy.

If you look at the period from the mid-1950s to the mid-1980s, debt to GDP (all our debt outstanding relative to our GDP) was about 150%. By the end of the 1990s, this ratio rose to 250%. And then, as households joined financial institutions in the borrowing binge, we hit 350% just before the financial crisis.

We have just begun to deal with the consequences of this massive debt burden, and investors are fearful that it will be a material headwind to economic growth and asset price appreciation. Every dollar used to pay down debt is a dollar that is not being spent on consumption or investment. No one knows how far or how fast the deleveraging will occur, but, in my view, until we reduce this debt burden, the U.S. economy is likely to remain weaker than historical norms.

However, the story on deflation is not one-sided. Even though the economic outlook appears weak, as Milton Friedman famously observed, “Inflation is always and everywhere a monetary phenomenon.”

U.S. Federal Reserve Chairman Ben Bernanke has made it very clear that he will not let deflation persist in the United States. He will use every weapon in his arsenal, and possibly a few that haven’t even been invented yet, to win this battle.

As the Fed continues to ramp up its balance sheet in an effort to stimulate the economy (e.g., QE1, QE2, and Operation Twist), I am concerned that this unconventional monetary policy could end up delivering unconventional, and unwelcome, results. The United States is in uncharted territory, and one cannot be sure that the Fed has either the willingness or the ability to rein in whatever inflation it creates in a timely fashion.

This is why I favor a position in long-maturity Treasury Inflation-Protected Securities (TIPS). Since the bond market is currently more worried about deflation than inflation, I believe that even a historically average inflation rate of 2.5% could lead to material outperformance by these bonds.

3. Default

With continued global uncertainty and the prospect of sovereign default in Europe’s periphery, there has been a quite rational flight to quality. Investors are saying, “The return of my money is far more important than the return on my money.” So long as international markets remain under pressure and U.S. Treasuries are deemed a “safe haven,” I believe strong demand will keep yields suppressed.

What should bond investors do today?

Given the volatility in all markets both here and abroad, fixed income products can still provide value even at historic low interest rates. There are some segments of the bond market that have done better when the economy falls into recession—like U.S. Treasuries and agency debentures (debt issued by a federal agency or a government-sponsored enterprise [GSE] for financing purposes)—and others that have done better when the economy accelerates—corporate investment-grade and high-yield bonds and TIPS. The key, in my view, is to have a well-balanced portfolio that can withstand today’s rapidly changing macroeconomic environment.

Corporate bonds have done relatively well this year. Looking at year-to-date numbers as of October 31, the total return for investment-grade corporates was up about 8%.2 That’s compared with high yield, which was up 4.5%,3 and the S&P 500® Index (.SPX), which is essentially flat for the year. However, corporate bonds have lagged intermediate-term Treasuries, which rose about 12.5% on a total return basis year to date.4 That’s largely because, in August and September, corporate yields remained stable, around 3.75%, while the 10-year Treasury yields have declined, pushing prices up.

Corporate bonds offer additional yield relative to government bonds, primarily as compensation for higher default risk. The extra yield on investment-grade bonds is higher today than any period in the last 20 years, except for the 2008-09 financial crises and the peak of the early 2000s recession. High-yield bonds (those rated below investment grade) offer even more yield, albeit with more risk.

Corporate bonds could outperform in a number of scenarios. If the U.S. economy surprises to the upside, or if eurozone leaders find a way to calm the market, or the U.S. government tempers its intervention in the bond market, Treasury yields could rise and corporate bond yields are likely to remain stable, generating potential relative outperformance. If, on the other hand, the economy stagnates and we stall out in a low growth/low inflation environment where Treasury yields remain low for an extended period of time, corporates may outperform as investors look for yield in a market where yield is scarce.

A number of factors continue to weigh on the market. In the short term, flare-ups in Europe have caused spikes in volatility which hurts corporate bond performance. In the medium to longer term, liquidity in corporate bonds has diminished somewhat due to persistently high volatility, increasing regulation of market makers, and the ongoing deleveraging of bank balance sheets. And of course, if the economic recovery proves unsustainable and we slip back into recession, corporate bonds could underperform.

In conclusion, corporate bonds are not without risk, but given the current yield advantage of corporates over government bonds, investors have been more than adequately compensated for that risk. Rising Treasury rates would be a headwind for returns, but the excess yield in investment-grade corporates and high-yield bonds offers some protection in such an environment.

 

 

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