February 3, 2014

The Bonds Conundrum: Where to Invest Now?

NHL great Wayne Gretzky was famous said he didn't skate to where the puck was, but rather to where it was going to be. I suppose this can apply to almost any area of life, especially to financial advisors. In short, if we knew where the puck, or rather the economy and financial markets, were going to be, we could design an excellent portfolio, one which captures all of the upside without surrendering much on the downside.

However, as anyone who's been in this business for any length of time will attest, this is a rather difficult task at best and impossible at worst. For example, in which direction are interest rates headed? Although the short end of the yield curve, that which is controlled largely by the Fed, is at zero and  likely to remain the, the intermediate- to longer-term portion of the yield cure is probably going to wave up and down, like a kite in a stiff wind. Because of this uncertainty, investing in this part of the yield curve is quite unpredictable.   

If you buy a high-quality, intermediate-term bond mutual fund, you're likely to receive an annual return ranging anywhere from plus or minus 6%, 7% or even 8%. If you invest in the long end of the curve  you're likely to be either a hero or get fired. Here's my point. Investing in bonds is risky, unless of course, you buy individual issues. At least then you have a more predictable return (assuming there's no default). The last time I bought a lot of individual corporate bonds was in February 2012, when the yield on the 10-year Treasury was around 2.0%. Back then, the yield to maturity on portfolio maturities of two to six years was around 5.0% to 5.5%. I figured the YTM would be slightly better now since the 10-year Treasury was up to 2.60%. However, a portfolio with the same maturities (and credit quality) only offered a YTM of 3.50%. It seems to me that yields have been squeezed and you have to go even further down the credit quality continuum to find an attractive YTM. 

When I look around the globe, I see many emerging economies struggling with high inflation, which is causing their central bankers to tighten. The situation in Europe, though eerily quiet, is much like it is here, albeit with a bit weaker GDP and higher unemployment. The most important economic statistic for U.S. stocks is the labor market. In December, the unemployment rate dropped all the way to 6.7% though we only added a meager 74,000 jobs. 

Here's something to consider. Are the financial markets in extreme dislocation? Are we vulnerable to some catastrophic or even milder event like the Turkish currency fluctuation? Clearly, we've never seen a time quite like this. As the Fed reduces QE, how will the world react, especially the emerging markets which have been the recipient of a good deal of "hot money" in the past few years?

I realize I have more questions than answers. But isn't that usually the case? 

Thanks for reading and have a great week!

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