Tactical bond strategies for low-rate environment

By Roman Chuyan, CFA

This is our tactical management update on our current view on the bond market, continuing with tactical asset allocation strategies that I outlined in our year-end Asset Allocation piece. and adding new strategies for the current low-rate environment.

Long-term interest rates continued to fall so far this year, with the 10-year Treasury yield declining from 2.71% in March (and from 3.0% at year-end), recently dropping below 2.40% (see chart below). At this point the Fed has already reduced its bond-buying from $85 billion a month to $35 billion, and the economy has improved and is growing, which is typically associated with higher interest rates. Yet, the 10-year yield is back down to 2.4%, which puzzled many observers .

10-Year and 30-Year Treasury Yields

Source: Ycharts

Two short-term factors are driving rates lower: (1) recent geopolitical concerns about Ukraine, and (2) market participants were betting on rates rising further, and now having to cover those positions. A more important, longer-term reason for lower rates, however, is the abundant global liquidity. While the Fed is reducing the rate of adding liquidity, the Bank of Japan, for example, is implementing a Fed-style QE program, and the ECB is about to take the bank deposit rate negative. Liquidity keeps global government debt yields at very low levels (see table). Compared to other developed sovereign yields, the U.S. 10-year yield is not very low – it is slightly above median. It is lower than the U.K. Italy, and Spain, but those all are significantly smaller economies. At these levels U.S. Treasuries are attractive to global bond investors; U.S. interest rates are not too low by global standard.

Sovereign Yields

As of May 30, 2014; source: Bloomberg

The U.S. economy is now growing at a healthy rate (preliminary estimate for Q2 GDP is 4%), after weather-related dismal performance in Q1. The end of the Fed’s QE stimulus is in sight, and inflation – while still below the Fed’s 2% target – is starting to pick up. All of these factors point to higher interest rates, but due to the global situation described above, I don’t expect rates to skyrocket, just to rise gradually toward year-end. S till, even under a moderate rise in rates (say, 0.5%) the loss in long-term bond value will fully offset income from corporate bonds, and more than offset the lower income from Treasuries.

Treasury Inflation-Protected Securities (TIPS) – Price and Breakeven Yield

With this in mind, I list below several tactical investment management strategies/ideas for sophisticated fixed income investors/advisors. These strategies aim to (1) reduce risk exposure to rising interest rates (2) at the same time preserve, or increase, portfolio yield, and (3) position the portfolio for additional gains from bond/income markets. All these ideas stay within traditional U.S. fixed income  markets, and not taking any commodity, global/EM risks, or leverage (multitude of such strategies are popping up, but they all are, well, risky)

Reduce long-term bond allocations in favor of the markets below – lower long-term yields/ higher prices currently present a good opportunity to do so, in my view. Invest in senior bank loans (via these ETFs: BKLN or SRLN ) that pay Libor plus a fixed spread, and are therefore not exposed to a rise in underlying interest rates. The spread is currently wide enough to give a total current yield of about 4.0% in the case of BKLN. Invest in Treasury inflation-protected securities, which offer valuable inflation protection. ETFs such as iShares TIPS Bond ETF (TIP ) provide an efficient way to invest. This is a very attractive entry point in my view, as the price is rebounding after a steep drop last year (see chart above). Invest in other alternative sources of higher yield – however. the abundance of leveraged and alternative products warrants caution. We like mortgage REITs (REM ) in this category.

Disclosure: we hold REM in our client portfolios.

This post was written on June 4, 2014; please contact us for updated views and analysis.

About Model Capital Management LLC: we are an investment firm focusing exclusively on tactical management. Please review the following pages for more information on Model Capitals approach to tactical management  and our tactical asset allocation models /strategies.

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