|Source: Capital Pixel|
There are others who take investing as a challenge. They like to try to "beat the market" - at least for a portion of their assets. They have a lot of time to study the market. They spend considerable time researching stocks but are stymied when it comes to the bond portion of their assets.
Should I Try to Predict Interest Rates?
Serious investors understand that bond yields and bond prices move in opposite directions. This, then, suggests that predicting interest rates is the natural way to outperform the bond market.
Sadly, as most professional bond managers will tell you, predicting interest rates is like predicting stock prices - it is a losers game. 2011 has been an excellent example of this. When yields had been considerably higher than where they are today, most pros predicted yet higher rates. Instead they dropped sharply; and, as a result, some of the most high-profile bond managers underperformed the bond market significantly. So much for predicting rates.
Trade the Spread
Instead, many pros will tell you it is considerably easier dealing with spreads. This is what I want to look at here.
A simple under-appreciated fact, IMHO, is that bonds are fundamentally different from stocks in that we know the future price of a bond. For example, if we buy a 5-year Verizon bond, we know that at the maturity date the price of the bond will be $100 (for $100 in principal). Obviously, if we buy Verizon stock, we have no idea where the price will be 5 years from now.
This gives special meaning to the much discussed "reversion to the mean" concept. Think about it like this: the price of a Verizon bond, for example, can wander all over the place depending on how investors feel about risk; but, in the end, it has to track closer to Treasury yields as it gets closer to maturity. This is true in spades when a portfolio of bonds is considered.
I find it interesting that professionals spend a lot of time studying and trading on the basis of yield spreads and yet, despite all of the investment information on line, yield graphs are not easy to find! In fact, I had to create my own data for this simple exercise to illustrate this idea of investing on the basis of yield spreads.
In thinking about what we are trying to do, first consider two bonds: a corporate bond and a government bond. Assume the Treasury bond yields 5% and the corporate bond yields 7%, i.e. the spread is 2%. Then, if the spread goes to 1.5%, it means that the price of the corporate bond has risen (or decreased less) relative to the price of the government bond - remember: bond prices rise when bond yields drop. The idea then boils down to this: buy corporate bonds when yield spreads are wide and you are getting paid to take on risk, and sell and go into Treasuries when the reward-to-risk is not so appealing. Professional bond traders spend a lot of time doing exactly this - studying yield spread graphs in their search for value.
So, to begin I first found some historical yields.
I collected monthly yields on Moody's Baa rated bonds (Baa is actually the bottom of the investment grade category) and the 5-year constant maturity Treasury note going back to November 2005. I then took the difference in the monthly yields and calculated the average. At the end of November, the Baa yield was 5.14%, the Treasury note yield was 0.91%, and so the spread was 4.23%. The average over the whole period for this spread was 3.58%. So, as a first cut, a bond trader would say the Baa corporate "has value."
On the other hand, if the spread was less than the average of 3.58%, bond traders would typically prefer the Treasury. In other words, they would say an investor is not getting paid enough to take on the risk of the corporate issue.
Hopefully you get the idea at this point - the adept trader who sold corporates on 4/2011 at a spread of 3.95% could buy them back considerably cheaper on 11/2011 at a spread of 4.23%.
Let's go a step further and think about the best way for a DIY investor to exploit spreads. For this purpose, I collected price data, back to 4/2007, on HYG (high yield bond ETF) and IEF (7 - 10-year Treasury note ETF). A significant positive here is that these are low-cost, highly-diversified investment instruments appropriate for the DIY investor. HYG is a good choice for up to 5% of a portfolio for the fixed income portion of most DIY portfolios. The question is when is a good time to buy?
Below is a partial listing of my data. The difference here is that we are looking at prices. The prices of the funds go up when bond prices rise, i.e. yields fall. If yields on high yield corporates fall more than yields on Treasury notes, then HYG will rise more than IEF will and vice versa. The spread reflects confidence in the economic recovery, etc. When the spread is large (on an absolute basis), it means you have to pay a lot (example: 10/2010 at -12.52) for the safety of Treasuries - this is the time to buy HYG! As you can see, by early 2011, HYG had appreciated in price (from 83.04 to 86.93) and IEF had actually declined! If you go to the earlier chart and collect the yield data, you'll find that the spread over the same period dropped from 4.59% to 3.92%!
Hopefully this gives you a bit of an idea how spread information can help position the fixed portion of the portfolio. There are, of course, other areas of the market, including mortgage-backeds, single-A corporates, etc., where this approach can be used profitably. Keep in mind that the yield advantage of sectors relative to Treasuries brings time into the process. This post is intended for educational purposes. Individuals should consult with a professional and do their own research. I hold ETFs mentioned above.