Don’t Stretch For Yield

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Just this week a few clients have inquired about the wisdom of putting more money into fixed income securities.  It is clear that retail investors did exactly that with a vengeance in 2009.  Bond mutual fund purchases out-paced stock fund purchases by a large margin.

By dropping short-term interest rates essentially to zero, the Federal Reserve did its best to force investors out of risk-free treasury securities into riskier investments.  Those who complied have largely been rewarded so far with strong returns.  As always, it is important to remember that we can’t buy past performance, only future performance.  The investing public has a long history of buying what has just done well.  Having observed past performance data, they draw an anticipated positive trend line into the indefinite future.  To make a prudent decision about adding fixed income securities, the investor needs to evaluate present and probable future conditions.

Year-end figures clearly demonstrate that, coming off the spring of 2009’s panicky conditions, those willing to accept the most risk garnered the greatest rewards.  Barclays Capital U.S. Aggregate Bonds earned a moderate return of 5.93%.  Those eager to stretch for yield in Barclays Capital High Yield Bonds, i.e. junk bonds, were rewarded with a 58.21% return.  The few willing to put money in CCC-rated bonds–a short step away from default–more than doubled their money in 2009 with a 112% return.  Those unwilling to bear any credit risk but prepared to hold long maturities lost 13.17% of their money in Barclays Capital Long-Term Treasury Bonds.  Those ready to bear neither credit nor maturity risk protected capital but earned virtually nothing (0.16%) in Three-Month U.S. Treasury Bills.

The willingness of the U.S. Government to purchase fixed income securities directly and to offer rescue assistance in a variety of forms has greatly bolstered confidence among fixed income investors.  Some government purchase programs, such as that for mortgage-backed securities, are scheduled to end within the next few months.  It is impossible to predict whether or not the political will to permit such government action will continue in the year ahead.  Whether or not fixed income markets can remain stable without government support is an open question.

We addressed the question of buying corporate or municipal bonds in “Why Not Buy Bonds?”, our September 28 blog post.  Refer to that post for our thoughts regarding corporates and munis.

Interest rates on longer U.S. Treasury securities have risen strongly over the past year. Since December 2008, the U.S. 30-year bond has seen yields rise from just over 2.5% to 4.7%.  The 10-year has risen from just over 2% to 3.8% over the same period.  Holding those bonds over that span of time was a losing proposition.  When treasuries reached their peak yields in June, we purchased the 10-year at a 3.98% yield with the expectation of a significant decline in rates over the months ahead.  The decline came quicker than expected, and we ended up taking profits on our bond position a month later at 3.33%.  (Prices go up as yields come down.)

Although we are wary of the possibility of rates going substantially higher in the years ahead, such moves typically take time.  Should long rates continue their rapid rise over the next several weeks, we would evaluate the attractiveness of a similar bond purchase in 2010. Currently, we are looking at the 4.25% level in the 10-year as a possible target area at which we might add bonds to our portfolios, depending on other conditions at that time.

As we have indicated in prior posts, we anticipate that highly uncertain economic conditions could lead to a significant pickup in market volatility in 2010.  We think it wise for portfolios to hold larger than normal levels of short-term cash and thus be positioned to take advantage of opportunities that could arise suddenly in the stock or bond areas.

For investors looking for complete security, we urge you to look at government guaranteed certificates of deposit, despite discouragingly low yields.  To prevent poorly capitalized banks from attracting too much money with above-market rates, the FDIC has restricted banks to CD yields no more than 75 basis points above a national average.  That has currently brought 12-month CD maximums down to about 1.65%.  In our view that is too little compensation for keeping funds tied up for a year.  We would instead encourage conservative investors to keep CD maturities as short as three months, which currently produces a return of about 1%.

While we could see short rates stay this low for the entire year, especially if business conditions remain weak, a real possibility exists for a sharp rate increase should inflationary fears arise or should the Fed be forced to raise rates to defend a weak dollar.  The extra return available is insufficient to justify tying funds up for long in an environment in which dramatic surprises are entirely possible.  Ideally, CD maturities should be laddered so money is regularly available to take advantage of more lucrative opportunities that could arise quickly throughout the year.

Tom Feeney is the chief investment officer for Marathon Asset Management Co, a registered investment advisor with the Securities and Exchange Commission, and for Mission Management & Trust Co., a full service trust company regulated by the Arizona Department of Financial Institutions. If you would like to explore the management of an investment portfolio of $1 million or more by either of the firms, you are invited to email your interest to or call (520) 529-2900 to speak with one of the Portfolio Coordinators.