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Thursday, December 27, 2012

Bond Market Sector Choice

A lot of ink has been spilled on the bond bubble theme and the concern that investors are in for a shock if yields rise sharply. Part of this involves extending duration and part is about going into riskier parts of the bond market.

The question here is:  is this a good time to add riskier sectors?  How do professional bond traders approach this question?

Close followers of the bond market contrast the present situation with the recent past.  In the past, the bond portion of an asset allocation could easily be satisfied with an index fund tracking Barclay's Aggregate Index.  This index is a market-weighted index comprised of investment grade issues having a maturity greater than one year.  It includes Corporate Bonds, U.S. Agency issues, Mortgage-Backed securities, and U.S. Treasuries.

But this was in the old days.  This was when the 10-year Treasury note yielded north of 4%.  Today the yield is 1.77%.  Furthermore, the duration on the index is 4.4 years and the index yield is 1.6% (SEC yield).  Also, as the U.S. Treasury has run chronic deficits exceeding $1 trillion, the U.S. Treasury portion of the index has expanded to comprise greater than 30% of the Barclay's index.

These developments are the culprit behind the well-publicized search for yield.  This search has led investors to high yield bonds, emerging market bonds, and other nooks of the fixed income market.

Professionals Trade the Spread

Professional bond traders look not just at maturity and duration but also at spreads.  They ask, for example, whether the yield spread on corporate bonds as a sector compensates for the incremental risk.

Recall that bond prices rise when yields decline.  Consider bond A (a corporate bond) and bond B (a similar Treasury note ).  Assume that Bond A yields 1.50% more than B, i.e., the spread is 150 basis points.  If the spread narrows to 1.20%, say, then that means that the price of bond A has appreciated relative to bond B.

Typically there is a big deal made about regression to the mean, so the idea is to buy when spreads are wide and sell when spreads are tight and then profit when spreads return to their mean.  This is not easy to do, as most professional bond traders will attest, but it is the objective.  Some are adamant that spreads are easier to trade than levels.  If you don't buy this, just recall that almost everyone in the market last year this time were absolutely certain that yields would rise in 2012!

So,what does a yield graph look like and what is it telling us?  CLICK IMAGE TO ENLARGE

This is a comprehensive spread graph.  It is for the overall investment grade market and adjusts for prepayment options and callability, etc.  See the description at the link for a complete definition.

The graph reveals that spreads are fairly tight, i.e, the bond market today isn't offering great compensation for taking on sector risk despite the low Treasury yields.

Some would argue that, if spreads tighten a bit more too close to the 1% level, it would be a good exit point.

You'll note that the best time to invest is, in fact, the scariest.  THERE'S NO FREE LUNCH HERE! Back in 2009, the spread exceeded 6%; but this was when the economy was imploding, bankruptcies were rampant, and corporate bond downgrades were on the rise.  The financial sector was especially taking it on the chin.

Disclosure:  This information is for educational purposes only.  Individuals should do their own research or consult a professional before making investment decisions.

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