Oct. 1, 2004 — Bond markets have entered the twilight zone.
Despite an environment of rising interest rates, bond funds have performed reasonably well this year, outperforming equities when many observers expected fixed-income portfolios to collapse. The average high-quality bond portfolio is up 2.3% through September 30, including a 2.3% gain in the third quarter.
A confluence of disparate trends, including sluggish economic growth in the U.S., soft job data, geopolitical tensions, terrorism fears, and the surging price of crude oil, have led some investors to seek the safe-haven of bonds. Consider that since the Federal Reserve raised its Fed Funds rate in mid-September — the third such hike since June 30 — the yield on the U.S. 10-year Treasury actually fell.
"This has been unusual", said Steven J. Kaseta, co-manager of Loomis Sayles Investment Grade Fixed Income Fund (LSIGX), one of the year's top-performing portfolios. "This divergence of behavior reflected the market's belief that the Fed's pace and magnitude of tightening will be less than what had been previously expected. The upward push of oil prices and soft economic data has exacerbated this scenario."
But Kaseta is not too surprised by the resilience bonds have demonstrated this year. "We have actually seen longer-term — the 10-year to 30-year — interest rates decline this year, despite the Fed's shifting monetary policy to a tightening mode," he said. "The yield curve is flattening, reflecting the fact that short-term rates have climbed higher. Inflation has also remained subdued and the spike in oil prices, which typically dampens economic growth, has created a favorable backdrop for bond investors."
John Derrick, director of research at U.S. Global Investors and manager of all four of their fixed-income funds, said that bonds are losing some of their safe-haven luster. "Bonds have performed pretty well largely because investors believe that the economic recovery will be slow and gradual, and that inflation will be benign," he said. "I don't think that investors suddenly move to bonds because of some bad news on the geopolitical front."
Kaseta explained that when long-term rates decline and short-term rates rise, the impact on bonds depends upon where along the yield curve one is invested in. "In this type of flattening environment, the optimal portfolio structure is to be bar-belled," he noted. "We expect the yield curve to flatten still more."
The surge in oil prices has been interpreted by bond investors as a warning of an economic slowdown, Derrick said, not necessarily as a harbinger of inflation. The bond markets have an overly-optimistic view of inflation, Derrick believes, and this has pushed yields down to unsustainable levels. In fact, Morgan Stanley recently recommended that investors reduce their exposure to bonds, citing these concerns.
Longer-term government bonds have delivered among the best year-to-date returns within the high-quality bond sector. "Long-term government issues are purely sensitive to long-term interest rates," Kaseta noted. "The 30-year Treasury has fallen from 5.07% at the beginning of the year to about 4.86% currently. The longer the maturation, the better the returns." Kaseta cautions, however, that long-term interest rates will soon move higher, along with short-term rates, in accordance with the Fed's tightening bias.
Kaseta expects the Fed to raise the Fed Funds rate by another 25 basis points before the end of the year, bringing it to 2.00%. By the end of 2005, he notes, rates should rise to about 3.50%. "In anticipation of these hikes, we are positioning our portfolio by gradually bringing our average duration downward so we reduce our sensitivity to interest rates," he said. "Unlike 1994, the Fed will not boost rates aggressively."
Kaseta believes that as long as inflation remains benign, bonds will perform adequately, regardless of higher interest rates. "The economy should grow at such a pace that it will benefit corporate balance sheets, providing more pricing power, improved earnings, some debt relief, and higher free cash flow generation," he said. "As such, we think longer-dated corporate bonds, both investment-grade and high yield, have the best upside looking into next year."
