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Bond Supply to Get Tighter in 2012—Good Thing for Buyers: LPL’s Valeri

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The U.S. bond market outside of Treasuries is shrinking, and the lack of growth could very well reduce interest rate risk while benefiting some market sectors with attractive bond valuations and higher yields, according to Anthony Valeri, LPL Financial’s market strategist, in a report published this week.

Valeri predicted that the 2012 bond market will see only “negligible” growth, in a repeat of 2011.

“We believe the bond market will exhibit negligible growth in 2012 in a near repeat of 2011,” Valeri wrote in a note published Tuesday, The Incredible Shrinking Bond Market. “Consensus forecasts call for MBS, agency and commercial paper markets to continue to shrink in 2011, municipal bond market growth to be flat, and corporate bond market growth to be modest again.”

Fed policy, economic growth and inflation expectation are the primary drivers of bond yields, but supply and demand factors are also relevant for bond investors because they can have a secondary impact on bond market yields and valuations, he noted.

“When it comes to debt market supply, steady Treasury issuance garners most of the headlines. A closer look at the broader bond market, however, reveals that the bond market is exhibiting virtually no growth, and after taking into account Federal Reserve purchases, the bond market is actually shrinking,” Valeri wrote.

He pointed to the Fed’s quarterly flow of funds data as of Dec. 31 in making his argument, which shows that the broad U.S. bond market saw almost no growth in 2011, expanding by “a paltry” 1%.

Fed data show that Treasuries grew 11% in 2011 versus 2010, to $10.4 trillion from $9.4 trillion. Mortgage-backed securities (MBS) fell 2%, to $13.5 trillion from $13.8 trillion, while municipal bonds were off 1%, to $3.7 trillion from $4.8 trillion. However, corporate debt grew 4%, to $7.8 trillion from $7.5 trillion.

Bonds available for bond investors were reduced by the Fed’s Treasury purchases from its second round of quantitative easing (QE2) as well as reinvestment of maturing Treasuries into additional Treasuries and government agency MBS later in 2011, Valeri said.

If the Fed initiates new bond purchases, growth may once again be negative, Valeri said, pointing to a Wall Street Journal article last week that suggested the Fed is considering a variation of “Operation Twist” quantitative easing that may expand long-term Treasury purchases beyond its current June 2012 expiration.

However, The Journal on Thursday reported that bond market investors are storming out of Treasuries and driving yields to their highest level since October “amid a view that the economy is picking up enough steam to keep the Federal Reserve from a new round of bond buying.”

Investors interpreted the Fed comments from Tuesday on the stregthening of the U.S. economy as a sign that the Fed “may not feel so much pressure to prop up financial markets,” The Journal said.

Read High-Quality Bonds in 2011 Saw Best Performance Since 2002: LPL’s Valeri at AdvisorOne.