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How the Bond Markets React 01.02.05
Bonds take a Holiday
Much to the dismay of fixed income investors, who were hoping for something better than what transpired, the turning of the calendar found bonds about where they were twelve months ago. And that simply wasn't supposed to be.
At the beginning of 2004, everyone believed that this was the year the Federal Reserve would raise rates putting an end to their free money policy. The only thing that was being actively speculated on was the speed and the harshness of those increases. Inevitability was never even a consideration. It had to be done.
The expectation that yields would rise on the 10-year Treasury as well it seems turned out to be wishful thinking. Why did the rate of 4.5% hold steady, actually falling after a close brush with the widely predicted 5% yearly return before Greenspan began his tightening? There has never been any argument about the tightening, the need for it, and generally the overdue-ness of it. But the reaction of this relatively short term fixed income investment was a bit of a surprise.
Investors it seemed were concerned about two things in '04: risk and the lack of it. Corporations issuing bonds found the low interest rate environment a fertile place to refinance some of its own debt and because these were generally highly rated companies, the yield offered was not so inviting. Add to that the dramatic decline in defaulted bonds and investors were left chasing emerging markets for returns they thought would be easy to get otherwise..
This lack of risk has bond fund managers and investors worried about a marketplace that has become the norm for the equities traders over the last two years. These managers are evolving into active pickers reluctantly chasing each undervalued issue like their stock brethern have been inclined to do recently. The problem they are facing is a market that is overpriced and overvalued. The biggest losers in such an environment are pension funds and insurance companies. These groups have specific rate return targets that are becoming increasingly harder to find.
The only real certainty is the continued increases by the Fed. Beyond that, the best that can be hoped for is a gradual widening of the spread between Treasuries of similar duration and high yield bonds. The current spread is too close for comfort from a historic standpoint.
The stock market is overpriced. Bonds have followed equities making it extremely difficult for fixed income investors to find anyplace worthwhile to park their money without assuming additional risk. What has become evident though is that this is not a market to be reaching for more than 3-5% above Treasuries. Especially with the understanding that government bonds are overpriced as well.
One survivor has been the long term notes which is not as attractive when everything seems so short term.
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