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Portfolio > Mutual Funds > Bond Funds

How to Play the Bond Market as the Yield Curve Flattens

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The yield curve will continue to flatten as the Federal Reserve raises short-term rates several more times while long-term rates edge only slightly higher, according to strategists at Schwab Center for Financial Research.

But that doesn’t mean fixed income investors should expect a recession is around the corner or favor only the short end of the curve, says Kathy Jones, chief fixed income strategist. She notes that many clients are buying short-term CDs and Treasury bills but as the cycle progresses, they should add duration, moving  beyond two-year issues for some portion of portfolio. “No one has a three-month time horizon for investing,” says Jones.

The current spread between two-year and 10-year Treasuries is around 25 basis points, down from 85 a year ago and 125 basis points in January 2017. Ten-year Treasuries are yielding just over 3% and two year-notes near 2.8% while the federal funds rate ranges between 1.75% and 2%. It’s expected to rise another 25 basis points following next week’s Federal Open Market Committee meeting.

Collin Martin, director, fixed income at the Schwab center, who spoke with Jones at a morning meeting with reporters, says it will take two to three more Fed hikes before the yield curve flattens, and the flattening is not a signal of impending doom.

Longer term the explosion of the U.S. government debt, however, will be problematic. The debt-to-GDP level is now 104%, due in large part to the recent tax cuts that will add about $1.5 trillion to the deficit over 10 years. “You have to finance the deficit with debt issuance and at a certain level investors will demand high yields,” says Jones.

She says the growing debt-to-GDP ratio is “worrisome” and could crowd out private investment at some stage if its growth trajectory doesn’t slow. “I don’t believe we can grow out of it,” says Jones, refuting the argument propagated by supporters of the tax cut.

“We are in a slow-growth world … and we will have problems for a generation,” says Jones, referring to changing demographics including an aging population not only in the U.S. but in China, Japan and many European countries.

An acceleration in GDP growth requires people working longer and productivity increasing, but even those changes won’t be enough to outpace the rapid growth of debt in the U.S., says Jones.

Other concerns for the bond market and economy in the longer term, according to the Schwab strategists, include:

  • Shrinking liquidity in the global bond market, which is especially damaging for emerging market debt (Schwab is underweight EM debt)  
  • Exploding corporate bond issuance, which has doubled the supply of high-yield debt and exploded the supply of BBB investment-grade debt. BBB debt now accounts for about half the investment-grade market, says Martin, adding that many of these bonds could potentially be downgraded to junk in a recession.
  • Intensification of trade tariff disputes. China could retaliate not only with its own tariffs on U.S. imports but takes nontariff retaliatory measures such as shipping fewer products to the U.S., retaliating against U.S. companies operating China or letting the Yuan slip in value, says Jones. “Don’t just look at percent of GDP affected and say ‘no big deal.’ “

Her advice to clients: the “tried and true bond ladder,” which includes bonds of various maturities, not bond funds or ETFs. The ladder can be structured to provide monthly income, which is especially appealing to investors in retirement, says Jones.

She recommends starting with two-year bonds on the first rung and then including bonds up to eight-, 10- or 30-year maturities, depending on the client’s preferences. Laddering can be especially useful when rates are rising because as the bonds mature the proceeds can be reinvested into higher yielding securities.

Collin suggested that investors who favor munis because of the tax-exempt interest payments compare the tax-equivalent yield of a muni bond to the yield of a comparable maturity Treasury and corporate bond. “In many cases a corporate bond or Treasury will make more sense.”

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