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July 05, 2005 at 08:00 PM
As the U.S. economy appears to be on solid footing, with inflation in check, consumer confidence picking up, and short-term interest rates still at relative low levels, high-quality bonds delivered modestly good results through the first half of 2005, performing nicely in the second quarter.
The average high-quality corporate bond rose 1.5% over the first half of the year, while the average government securities fund edged down 0.07%. In the second quarter, the average high-quality corporate bond fund rose 2.4% and the average government bond fund gained 2.7%.
One peculiar wrinkle on bond markets, however, has been what Federal Reserve Chairman Alan Greenspan has described as a “conundrum:” the fact that as short-term rates have risen due to Fed tightening policy, long-term rates have inexplicably remained flat, or even decreased. Long-term Treasury bonds have delivered the strongest returns among this sector year-to-date. They also assume more risk.
Cathy Roy, chief investment officer for fixed income at the Calvert Group, explained that long-term Treasuries have prospered due to the continued appetite for absolute yield from investors, particularly from foreign buyers and hedge funds. “The yield curve at the beginning of the year was also sufficiently upward sloping, so it rewarded investors for taking on longer maturities,” she said. “The yield spread between the two-year and 30-year Treasuries has narrowed over 100 basis points since year-end 2004. At some point, the small incremental pickup in yield on longer Treasury securities should slacken investor demand.”
The worst-performing portion of the bond markets has come from lower-quality credits, Roy noted. “Absolute lower rates and tight spreads have finally started to get investors a bit nervous about loading up on more risky assets.” she said.
The Fed has raised short-term interest rates by 225 basis points over the past year to 3.25%. However, the 10-year Treasury yield recently hit 3.80%, a 15-month low; and bond yields, in general, have been steadily dropping for the past year. Roy is “surprised” that longer rates — beyond 5 years — have been declining.
“With GDP growth at 3.5% and reported inflation hovering around 2.5%, the fundamentals simply don’t support a 4.00% ten-year yield,” she said. “We expect the yield curve to start to become steeper at some point as longer rates move higher, and the Fed stops tightening.” Standard & Poor’s expects the Fed Funds rate to finish at 4.00% by the end of 2005, while Roy has a 3.75% target.
