Abond is a loan. That’s it.

You loan your money to a Government or a Corporation and they promise to repay you the money you lent to them at a certain date in the future.

To make it worth your while, they also pay you interest every 6 months. From the get go, you know when you’re supposed to receive your interest and how much it’s going to be.

If the Corporation or Government fails to pay you the interest on the dates that were set out, they are in “default”. You can then take legal steps against them because they had a legal obligation to pay you.

There are bonds that are backed up by specific assets like equipment and real estate. If you own this kind of bond (called “collateralized bonds”) you can sue and try to get the assets that back up the bonds. If your bonds are not backed up by any specific assets, you are a general creditor and in a less secure position. As a result, unsecured bond holders demand higher interest rates than secured bond holders.

As I said, when you buy bonds, you know when you are supposed to get your money back and when you’re supposed to collect your interest. As long as you hold on to the bonds until they mature, and as long as the issuing body is solvent, you’ll get your money. But if you need to sell your bond before they mature, you may get more or less money for those bonds. The reason is that interest rates change.

Generally, as interest rates in the market rise, the value of bonds drop. That’s because the interest on bonds that have already been issued is fixed. The interest payment you receive doesn’t go up or down as I mentioned. That being said, if interest rates are higher today than they were a year ago (for example) a new investor could get more interest on her investment if she buys new bonds. If that’s the case, the only way you’ll be able to sell your bonds in a rising interest rate environment is to ask less than what you paid. Makes sense?

So the value of your bonds is determined by how long it will be until they mature. Generally, the longer the maturity the greater the risk (more time for things to go wrong). Also, if the company encounters financial trouble, the bonds are going to go down in value. That’s because nobody else will want to buy them from you if they can buy more secure bonds at the same price.

In short, if you own bonds, you have to think about how long until they mature, how strong the issuer is and where interest rates are.

Are bonds the best investments to make now?

Over the last year, lots of investors pulled money out of the stock market and dumped that cash into bonds.  Especially those who want to have enough money to retire.  

That’s because they were afraid of investing in the stock market and needed some place to park their money. So, because so many people were competing to buy bonds, the prices went up. As the prices rise, the return goes down (relative to the money you invested in the bonds). If you buy a bond that pays 4% and has a face value of $100,000, you will receive $4000 in interest every year and that won’t change.  But if you paid $110,000 for the bond because you had to compete with other investors to buy it, you earn much less than 4% on your money.  Right?

With rates at historic lows and with many States and Municipalities facing severe financial challenges, do you think this is the time to buy bonds?

The following is a guest post from Neal Frankle. He is a Certified Financial Planner in Los Angeles. He also blogs over at Wealth Pilgrim.

photo credit: Dread Pirate Jeff

Over the past four weeks, the combination of lower Treasury yields and higher inflation fears suggests the bond market may be signaling the return of stagflation. Normally, higher inflation expectations would translate into lower bond prices and higher yields as investors demand protection from rising inflation that erodes the value of bond investments over time. However, the fact that high-quality bond yields declined over the past four weeks while inflation expectations increased suggests that the bond market may be pricing in both slower economic growth and higher inflation, otherwise known as stagflation.

The mention of stagflation conjures up memories of the 1970s. For investors, it does not mean bell-bottoms and big-collar shirts but rather a period of merely average economic growth but with above-average inflation.

U.S. Economic Growth

Economic growth, as measured by gross domestic product (GDP), averaged 3% in the 70s while inflation, as measured by the consumer price index (CPI), averaged just over 7%. Job creation was problematic for much of the decade as well. Unemployment rose above 6% in late 1974 and did not fall back below that threshold until the middle of 1978. These elements are in play today but to varying degrees.

Overall economic data for the U.S. economy has been robust but job creation, the ultimate test of an economy’s vitality, continues to be lackluster. Last Friday’s employment report showed that employment continues to improve but at a very sluggish pace. Meanwhile, lingering Middle East turmoil has helped keep oil prices above $100 per barrel. Since higher energy prices act as an added tax on consumers and consumer spending accounts for nearly 70% of economic growth, lower bond yields reflect the bond market pricing in a slower pace of economic growth going forward.

What’s the Fed Up To?

Last week, the Federal Reserve’s Beige Book release, a qualitative and monthly report on regional economic conditions, added fuel to inflation fears. The Beige Book reported that some firms are having initial success in passing on higher input costs to end users or consumers. The report runs contrary to the belief that the economy is not strong enough to handle higher prices. The ability to more easily pass along higher costs reinforced inflation fears.

We believe it is too early to declare a return to stagflation. We are watching recent developments closely but it may simply boil down to uncertainty weighing on bond investors. On the one hand, economic data continues to improve and in some cases, such as last week’s Institute of Supply Management (ISM) survey, is very strong. On the other hand, rising energy prices are a concern and may slow future economic growth. However, today the U.S. economy is more energy efficient and much less dependent on oil than it was in the 1970s casting doubt at what level oil prices truly impact the economy. In addition, recent Treasury strength is also attributable to Middle East turmoil and fears that geopolitical risk may spread to more systemically-important countries such as Bahrain or Saudi Arabia.

Bond market uncertainty is also reflected in sector performance.

Over the past four weeks (ending March 7, 2011), sector performance among Treasury, mortgage-backed, investment-grade corporate, emerging market debt, and high-yield bonds has held in a narrow band. TIPS are an exception, however, and have benefited directly from higher oil prices.  The lack of true sector leadership, aside from the oil-induced gains in TIPS, also reflects bond market uncertainty.

Today’s bond market bears little resemblance to that of the 1970s making it hard for investors to draw investment conclusions. Many domestic (e.g., high-yield bonds) and international bond sectors simply did not exist in the 70s. However, a simple glance at the 10-year Treasury yield shows that bond investors faced an uphill battle for most of the decade. Note the gradual nature of the rise in yields for much of the decade suggests downward price pressures. To what degree price pressures are offset by interest income depends on a particular bond sector or investment but today’s lower yield levels provide less of a cushion. As we have argued in the past, lower yields imply lower returns going forward. We forecast a low return environment for bonds in our 2011 Outlook, but should stagflation trends become more entrenched, bond investors will likely face a low return environment well beyond 2011.

We are watching recent bond market developments closely but believe it is too early to signal a return to stagflation. Lingering Middle East turmoil, which has contributed to high oil prices and safe-haven buying of Treasuries makes it difficult to discern a true trend. Last week’s Beige Book report was a warning shot that higher inflation may be here to stay even if geopolitical risks recede, but the lack of true sector leadership and decline in overall bond yields suggests recent bond market action merely reflects uncertainty.

***************************************************************

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific
• advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• The fast price swings in commodities and currencies will result in significant volatility in an investor’s holdings.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of
  principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.
• The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban
  consumers for a market basket of consumer goods and services.
• The ISM index is based on surveys of more than 300 manufacturing firms by the Institute of Supply
  Management. The ISM Manufacturing Index monitors employment, production inventories, new orders, and
  supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.
• The Barclays 5-15 year TIPS Index consists of Inflation-Protection securities issued by the U.S. Treasury with a maturity from 5 up to (but not including) 15 years.

Negative headlines on the AAA rating of U.S. Treasuries may increase in coming weeks if the Obama Administration’s new budget fails to include any incremental steps towards reducing the deficit. During his State of the Union speech, President Obama announced a freeze on discretionary spending but lacked details of a more substantive move to reduce the deficit. In January, both Standard & Poor’s (S&P) and Moody’s voiced caution on the outlook for the sovereign debt rating of the United States and may do so again. The outlook, which is different from an actual ratings downgrade, refers to an intermediate to longer-term ratings direction absent any improvement in credit quality metrics. Both Moody’s and S&P have indicated that they may change the outlook to negative from stable in the coming two years should the United States fail to make progress on reducing the deficit and a rising debt burden. Sovereign credit risk will likely be a theme in bond markets for years but what exactly does it mean for bond investors should U.S. Treasuries lose their AAA rating?

Multiple factors, not just ratings, impact bond prices and yields.

A ratings change often results in minimal change to a bond’s price. Japanese government bonds were downgraded by both S&P and Moody’s in late 2001. While Moody’s had already downgraded Japan’s AAA rating in response to the Asian crisis in 1998, the S&P downgrade ensured that Japanese debt was truly AA-rated. Despite the downgrade, Japanese government bonds still benefited from a powerful global government bond rally from early 2002 through the middle of 2003 in response to a recession, central bank rate cuts, corporate bond credit quality concerns, and deflation fears.

Last week, S&P downgraded Japan’s government bond rating to AA- from AA citing unfavorable demographics and a lack of progress on reducing one of the largest debt burdens among developed countries. Given the now increased scrutiny of government bond credit quality, an adverse market reaction seemed likely. However, Japanese government bond prices were little changed on the day as the “news” was, in actuality, hardly new to bond investors. Japanese government bond yields remain stubbornly below 2.0% due to a weak economy and a high domestic bond ownership rate, both of which are positives for bondholders.

Corporate Bond Ratings

In the corporate bond market, General Electric (GE) lost its long-held AAA rating in March 2009 but that event did not stop GE bonds from rising in price. GE bonds benefited along with the corporate bond market overall as investors returned to take advantage of attractive valuations in the wake of the financial crisis. Similar to the Japan example above, the downgrade of GE was not surprising to bond investors. Yields on GE bonds were already similar to other AA-rated corporate bond yields reflecting the fact that bond investors expected a GE downgrade at some point. Continued warnings over the AAA rating of Treasuries means that should Treasuries get downgraded in coming years, market impact may be limited.

Ratings changes are often not a market-mover as the bond market is a forward-looking mechanism and typically adjusts to credit quality changes in advance. For example, Greek government bond prices began to weaken during the fourth quarter of 2009 yet the rating agencies did not respond with downgrades until March and April of 2010. Today, Moody’s and S&P rate Greek government bonds Ba1 and BB+, respectively, yet the yield on the Greek 10-year note is 11.3%, a yield level that indicates a high probability of default from the bond market. The 11.3% yield is also higher than the average 9.1% yield on lower-tier high-yield corporate bonds rated Caa by Moody’s and CCC by S&P, according to Barclays High-Yield Index data.
Similarly, Irish government debt is rated firmly investment-grade by both Moody’s and S&P but Irish government bond yields are more commensurate with “junk” bond yields.

Government Bond Ratings

Part of the disparity between government bond ratings and market prices/yields reflects the fact that Moody’s and S&P apply more qualitative factors in assessing sovereign credit quality. Political risk, fiscal and monetary flexibility, and access to external funding are all factors unique to sovereign ratings rather than the more cut and dried mathematical approach applied to U.S. corporate ratings. Ratings agencies account for outside monetary assistance from the European Union (EU), European Central Bank (ECB), and International Monetary Fund (IMF) which helps explain why Greek and Irish bond ratings are not lower.

Therefore, investors will need to look beyond bond ratings for what the ultimate impact of a possible future ratings downgrade to Treasuries will mean. Market-implied barometers of credit quality can indicate to investors if a downgrade entails the persistence of relatively low yields (such as Japan) or the default risk implied by Greek and Irish government bond prices. Of course markets can overshoot as was the case with high-yield bonds following the financial crisis. The average yield advantage of high-yield bonds relative to comparable Treasuries briefly exceeded 20% at one point, a level that corresponded to a high-default probability for the entire domestic high-yield market. Similarly in 2002, the Enron and Worldcom fraud scandals fueled a corporate bond panic that led to inordinately low valuations across the corporate bonds universe. Both situations proved to be incorrect market assessments even if relatively brief. Nonetheless, we believe market-based indicators are worthwhile tools for investors.

Credit Default Swaps Pricing

The pricing of Credit Default Swaps (CDS) on U.S. debt and yield differentials between government bonds are two ways investors can observe the market’s assessment of U.S. credit quality.

• ƒƒCredit Default Swaps – CDS are essentially insurance contracts that help protect against the risk of default. Currently the 5-year CDS spread (or cost) for U.S. Treasuries is 0.5%, meaning that it costs $50,000 annually to insure a $10 million investment in U.S. Treasuries against default over a five-year horizon. A rising spread would indicate greater market expectations of default and vice versa. Current Treasury CDS levels are
  lower than the 0.6% spread for Germany and 0.8% for Japan.
• ƒƒGovernment Yield Differentials – Comparing yield differentials between 10-year Treasuries and 10-year German Bunds (or another top-rated government bond issuer) is another way to assess sovereign risk. Should yield differentials between U.S. Treasuries and German Bunds increase, it may reflect increased U.S. credit quality concerns. Yield differentials can be influenced by a number of non-credit related factors such as differences in inflation, economic growth, and central bank interest rate policy and therefore should be corroborated with other measures. Still, comparing yield differentials between peripheral European government bonds and German Bunds has been useful in assessing the degree of the European debt problem.

We believe the Obama Administration will stick to discretionary spending freeze outlined in the State of the Union speech without taking additional steps to trim the deficit. Given the strength in recent economic data, the administration will likely defer on more concrete, but potentially unpopular, moves to tackle the
deficit. This means negative headlines from the ratings agencies will continue and a possible change in the rating outlook remains a possibility.

For now the United States gets a pass. The monetary flexibility of the Federal Reserve compared to the European Central Bank (ECB) and European Union (EU) nations is a positive, as is the stronger growth prospect of the U.S. economy in 2011. Ultimately, a potential downgrade in coming years may not mean much to bond investors given the experience of Japanese government bonds and GE corporate bonds. The fact that bond investors continue to brush aside ratings warnings on Treasuries suggests that the bond market may already be getting used to the idea. This does not mean that current and future administrations should avoid embarking on reforms to address fiscal imbalances. Quite the contrary, we believe such action is absolutely needed and in the best interests of all U.S. bondholders, not just Treasury owners. However, a rating change may not be a game changer and investors would be wise to instead focus on market-based indicators for an assessment of Treasury quality.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
• Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• Credit Quality is one of the principal criteria for judging the investment quality of a bond or bond mutual fund. As the term implies, credit quality informs investors of a bond or bond portfolio’s credit worthiness, or risk of default.

Halloween is still several days away but the mortgage market has decided to spook the corporate bond market a bit early. The Mortgage-Backed Securities (MBS) sector was logically the first to come under scrutiny from the mortgage foreclosure problem but oddly enough, it is the Corporate Bond Sector that grapples with potential ramifications of the mortgage foreclosure mess. The possibility of “put-backs,” the process by which banks will be forced to repurchase a witches brew of non-performing loans and foreclosed properties back onto their balance sheets, has led to modest weakness in Corporate Bonds, concentrated primarily among bonds issued by financial companies.

The MBS sector will be largely unaffected by uncertainties regarding mortgage foreclosures. The bulk of the MBS sector, $6.7 trillion out of total MBS market of $8.9 trillion, is comprised of agency MBS issued by the government sponsored agencies of Ginnie Mae, Fannie Mae, and Freddie Mac. The agencies are required to purchase delinquent loans out of the loan pools that back mortgage-backed bonds no longer than 120 days after the loan becomes delinquent, long before foreclosure. The loan is purchased from the pool at par value so the bond investor does not suffer a loss, a factor that contributes to the AAA-rating of agency MBS.

Look For Delays

Delays in foreclosures may have a small impact in the smaller, non-agency MBS sector. Non-agency MBS, issued by banks and other financial institutions, may suffer delays in cash flow payment to investors. However, this impact is difficult to gauge as foreclosed loans are disclosed to bond investors well in advance and often treated as defaulted (with an assumed recovery value), all of which is factored into the price of the bond. The impact to non-agency bonds is likely on a case-by-case basis and not a market-wide event. Furthermore, since non-agency MBS are not included in popular bond market benchmarks, such as the Barclays Aggregate Bond Index or the sector specific Barclays U.S. MBS Index, non-agency bond exposure is relatively limited among bond mutual funds averaging less than 1%, according to Morningstar data.

However, uncertainty over mortgage foreclosures has spooked the Investment-Grade Corporate bond market. The yield premium, or spread, to comparable Treasuries has widened sharply over the past two weeks pushing overall investment-grade spreads wider in the process (chart 1). Yield spreads stabilized last week as strong earnings reports helped offset mortgage put-back fears.

photo credit: Truthout.org

The mortgage foreclosure issue will take time to resolve and may lead to continued volatility. Aside from possibly taking mortgage loans and/or properties back onto their balance sheets, uncertainty over potentially higher overall foreclosure costs and litigation risks may keep an eerie fog over the financial sector of the investment-grade corporate market. Since the banks and financial institutions are at the heart of the day-to-day functioning of capital markets, the impact of the corporate bond market on the financial sector is important to follow.

Ultimately, we believe other positive factors such as robust earnings, improving credit quality, and the prospect of large-scale bond purchases by the Federal Reserve will keep the goblins in check and outweigh the potential negative impacts from the mortgage foreclosure problem. Last week, Bank of America and Wells Fargo, two of three largest banks in terms of residential mortgage loans, offered a treat rather than a trick by reporting better-than-expected earnings helping to allay fears of mortgage put-backs. Early bank earnings reports, on balance, show that banks were able to release reserves held against potential losses as problem loans declined. In our view, an increase in required reserves over the prior quarters coupled with a decline in problem loans put the large banks in a position to weather the storm should mortgage put-backs become a reality. It is also worth noting that potential problems will likely be limited to the largest banks and not to financial institutions across the board as the recent Corporate Bond action suggests.

No Significant Risk

We do not see mortgage put-backs leading to any significant default risk for bond investors. In a potential signpost for the large banks, Moody’s stated that added expenses that may result from the mortgage foreclosure problem are not expected to adversely affect the ratings of Bank of America Corporate Bonds, the largest holder of residential mortgage exposure.

Furthermore, the prospect of another round of quantitative easing by the Fed in the form of large-scale bond purchases is likely to be a positive for corporate bond investors. We believe the Fed bond purchases will help push Treasury yields even lower and forcing more investors into higher-yielding Investment-Grade and High-Yield Corporate Bonds. We also believe the positive forces of good earnings and Fed purchases may outweigh the potential ghoulish impact of the mortgage foreclosure problem over the longer term.

—————————————————————————————————

IMPORTANT DISCLOSURES

• This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• An obligation rated ‘AAA’ has the highest rating assigned by Standard & Poor’s. The obligor’s capacity to meet its financial commitment on the obligation is extremely strong.
• Corporate bonds are considered higher risk than government bonds but normally offer a higher yield and are subject to market, interest rate and credit risk as well as additional risks based on the quality of issuer coupon rate, price, yield, maturity and redemption features.
• GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
• Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
• This Barclays Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
• The Barclays Mortgage-Backed Securities Index includes 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA).

photo credit: Silentmind8

Last week’s employment report pushed the Federal Reserve (Fed) one- step closer towards large-scale bond purchases. The September jobs report was only slightly weaker than consensus forecasts, but far from strong enough to convince Fed policymakers that the economy would not benefit from another dose of medicine. While Fed bond purchases seem increasingly likely, many questions remain about how exactly the Fed would implement such a program. A new wrinkle emerged last week, as bond market participants discussed the possibility of interest rate targeting. The possibility of bond purchases will remain a positive force behind high-quality bond prices. We continue to believe that more economically sensitive bonds may benefit more from Fed purchases.

Short to intermediate Treasury prices continued their march higher and yields fell by 0.07% to 0.15% (according to Bloomberg), as the September jobs report pushed the Fed one-step closer to large-scale bond purchases. Treasury Inflation Protected Securities (TIPS) prices increased even more than conventional Treasuries as investors sought inflation protection on the premise that Fed purchases would generate future inflation. Yield premiums on Investment-Grade Corporate bonds and High-Yield bonds declined on the week as Fed purchases are viewed as a positive for more economically sensitive bonds.

The concept of interest rate targeting emerged as a new wrinkle the Fed may pursue in implementing large-scale bond purchases. Under interest rate targeting, the Fed would essentially seek to set a ceiling on the yield of a particular Treasury security. For example, the Fed may target a 2.0% ceiling on the 10-year Treasury or a 1.0% target on the 5-year Treasury note. While the levels may vary, the focus maturities will likely range from 2- to 10-year

Treasuries, as these securities are benchmarks for a host of consumer loans, like mortgages, car loans, and home equity lines of credit.

The potential benefits of interest rate targeting include:

Clarity:

Rather than merely conduct Treasury purchases with the objective of generically lowering market interest rates, stating a specific yield level makes the Fed’s objectives clearer. Depending on how far the current rate is away from the Fed’s target, investors will know how much force the Fed intends to exert in order to achieve the desired interest rate. Investors would then be discouraged from selling if the yield strayed too far above the target and, conversely, investors might buy in anticipation of Fed purchases. In this way, the Fed could utilize the bond market as an ally in seeking its objectives, and perhaps achieving the same policy goal without having to buy as much debt in the open market.

Cost:

By announcing a yield target, the Fed may not have to announce a particular dollar amount. Setting a target enables the Fed to enter the market on an as-needed basis to achieve the desired rate. The European Central Bank (ECB) pursued similar logic in regards to purchases of troubled European government bonds. Purchases were substantial at first, and then tapered as fear receded and governments could fund effectively in the secondary market, and subsequently increased in September as concerns flared up among select issuers.

Fed Chairman Bernanke has already expressed his approval of interest rate targeting as an option. Bernanke, in a well-known speech in 2002, “Deflation: Make Sure It Doesn’t Happen Here”, stated that he “prefers” interest rate targeting as a method to lower Treasury yields and, in turn, lower key interest rates on public and private sector loans and other debts.

A large-scale bond purchase program would likely continue to help benefit more economically sensitive sectors such as investment-grade corporate bonds and high-yield bonds. In late 2008, the Fed lowered the Fed Funds rate to a range of 0.0% to 0.25% and followed up existing Mortgaged-Backed Securities (MBS) purchases with Treasury purchases. Throughout 2009, these actions forced investors into longer-term maturities in search of higher returns. This, in turn, created a domino effect, which forced government bond investors to buy higher-yielding corporate and high-yield bonds. We believe a large-scale bond purchase program would have the same impact this time as the insatiable search for yield forces investors in higher-yielding segments of the bond market. In addition, lower yields will extend the existing trend of investment-grade and high-yield issuers refinancing existing debt with lower interest cost debt thereby lowering their overall costs.

Three weeks remain until the Fed’s next policymaking meeting on November 2, but the bond market has already begun to do the Fed’s work. Since August 10, when the Fed first announced that proceeds from MBS would be reinvested into Treasury securities, Treasury prices have increased and yields have declined by 0.20% to 0.40%. Half of the yield decline came after the September 21 Fed policy making meeting when the Fed indicated inflation was below their goal.

While the potential implementation of how the Fed goes about bond purchases is unknown and could lead to volatile conditions, the prospect of large-scale Fed purchases both implied and actual will help support high- quality bond prices and keep yields low. We believe the 10-year Treasury yield will be range-bound between 2.0% and 2.5% until further clarity around the “how” of Fed purchases is clarified in coming weeks. Beyond the Fed meeting, we still expect high-quality yields to remain low with any rise in yields likely limited given the prospects of Fed purchases. Therefore, any rise in the 10-year yield is likely limited to 2.75% or 3.00%, in our view, as long as Fed purchases remain a possibility.

——————————————————————————————————————————

• IMPORTANT DISCLOSURES
• The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.  Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
• Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.

The bond market keeps going and going in 2010. The high-quality domestic bond market delivered another quarter of good performance with the Barclays Aggregate Bond Index returning 2.5% for the quarter and 7.9% year-to-date through the end of September. We expect performance to slow during the fourth quarter as the now even lower level of yields implies lower returns going forward. However, the Federal Reserve (Fed) may provide an additional catalyst should the central bank expand bond purchases in an attempt to stimulate the economy and we see limited bond market weakness over the fourth quarter.

A Rising Tide Lifts All Boats

Virtually all sectors of the bond market benefited from the decline in bond yields and corresponding rise in bond prices.  A steady decline in interest rates provided the bond market with a nice tailwind over the third quarter.  Intermediate and long-term bond prices benefited most from the decline in yields while short-term bond returns were more muted due to already rock bottom short-term interest rates that failed to match the decline in intermediate and long-term yields. Among government bond sectors, Mortgage-Backed Securities (MBS) lagged as fears over a refinancing wave led to price weakness later in the quarter.

More economically sensitive High-Yield Bonds and Emerging Market Debt (EMD) outperformed high-quality bonds during the period.  Credit quality fears from the European debt problem subsided over the summer prompting investors to refocus on strong underlying fundamentals and attractive valuations. Demand from income-seeking investors also benefited both sectors. Foreign bonds, un-hedged for currency movements, performed well as the Euro rebounded and debt fears subsided.

Performance in the municipal bond market paralleled that of the taxable bond market. High quality intermediate and long-term bonds outperformed short-term bonds while municipal high-yield bonds outperformed high-grade tax-free bonds. Even though the drumbeat of warnings about municipal credit quality continued, investors recognized the high-priority status of most municipal bond interest payments. Attractive valuations also benefited tax- exempt bonds.

As we look to the fourth quarter, we expect bond market performance to slow. The benign Federal Reserve and low inflation environment that benefited bonds during the third quarter looks set to continue; however, we believe the now lower level of high-quality bond yields already reflects this favorable backdrop.  Bond prices may remain relatively range-bound as Fed policy and economic data unfolds.  Interest income, and not price appreciation, therefore will be a greater driver of bond returns over the fourth quarter in our view.

High Yield Bonds Still in Favor

We continue to favor more economically sensitive bond sectors such as High-Yield Bonds, investment-grade corporate bonds, and EMD. Domestically, second quarter earnings reports revealed that debt issuers continued to improve key credit quality metrics. On average S&P 500 companies increased their interest coverage ratio and reduced leverage further. Late in the quarter Moody’s Investor Service reported that U.S. corporations have been actively refinancing existing debt maturities. The amount of high-yield and investment-grade corporate debt due between mid-2010 and the end of 2012 declined 37% and 18%, respectively. Not only does refinancing higher interest debt potentially bode well for improving the ability to service debt, but it also gives corporations the ability to avoid volatile markets and issue debt with uneconomical terms.

The high-yield market continued to benefit from a sharp decline in defaults, a trend we expect to continue over the fourth quarter. The Moody’s 12-month trailing default rate declined to 5.0% at the end of August with Moody’s forecasting a further decline to 2.7% through year-end 2010. With an average yield advantage of 6.4% above comparable Treasuries as of September 22, 2010, we believe valuations more than compensate investors for the risk of default.  Additionally, the average 7.9% yield-to-maturity is attractive in what could be a very low return environment for bonds.

Emerging market countries continue to exhibit stronger economic growth. Stronger economic growth bodes well for continued credit quality improvement and an enhanced ability to service debt obligations. The International Monetary Fund (IMF) forecast that EMD issuers on average will continue to reduce their debt burdens relative to the size of their economies, as measured by debt-to-GDP ratios, through 2015. Not surprisingly, the IMF forecast debt burdens of developed countries would continue to increase over the same period. The stronger fiscal position bodes well for EMD. However, similar to high-quality bonds, we expect the bulk of future performance to come from interest income generation as we find valuations attractive but close to fair value.

A double-dip recession is a risk to our preference for more economically sensitive bonds. A return to recession would likely lead to still higher high- quality bond prices and additional gains.  However, a double-dip recession would likely lead to underperformance of more economically sensitive bonds such as high-yield bonds and EMD.

Conversely, a sharp rise in interest rates could lead to bond price declines and the possibility of negative total returns. We place a low probability on such a scenario as the Fed remains committed to keeping interest rates low for an “extended period” and may err to the side of providing additional stimulus via expanded bond purchases. Even if the Fed does not announce additional bond purchases at its November policy-making meeting, it will likely state that they stand ready to take additional action as necessary to stimulate the economy which will keep the prospect of bond purchases alive. Although a decline in yields in response to Fed buying is far from certain, the prospect of Fed purchases, slow growth, and low inflation will likely keep any bond price weakness limited.

Like high-quality taxable bonds, we believe high-quality municipal bond performance may slow as average AAA-rated municipal bond yields are near historic lows.  Signs of weakness appeared late in the quarter as a surge in new issuance met lukewarm demand. Low yields caused investors to hesitate and if bond dealers cut prices to move recent new issues, a modest sell-off may ensue. On a positive note, valuations relative to Treasuries remain attractive with longer-term AAA-rated Tax-Free Bonds yielding more than taxable Treasuries. On a longer-term view, a supply-demand imbalance remains in effect with tax-exempt bond issuance on pace to finish 2010 at the lowest level in almost a decade.

—————————————————————————————————

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.
• High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
• The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
• Preferred Stock investing involves risk, which may include loss of principal.
• International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
• Investing in foreign securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
• Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
• Bank Loans are loans issued by below investment-grade companies for short-term funding purposes with higher yield than short-term debt and involve risk.
• Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between  companies and industries because it eliminates the effects of financing and accounting decisions.
• This Barclays Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

photo credit: Beverly & Pack

While you consider your retirement portfolio of investments, ask yourself a simple question. How steady is my fixed income portion of the portfolio?

First, let’s review: there are 3 major classes to consider when allocating our assets (what investments to buy with our savings for retirement):

• #1 Cash/near cash liquidities (Found in money market accounts or high yield savings account)
• #2 Fixed income (Bonds, certificate of deposits or preferred shares)
• #3 Equities (Companies listed on the stock market)

Further detail on the other two classes can be found in our series on asset allocation, today’s focus is on fixed income. The major types of investment vehicles in this class are: bonds, debentures, preferred shares. The goal behind these investments is to deliver an income that is certain or “fixed”.

Fixed Income Definition:

Fixed income products are sought after by investors to bring stability to your portfolio. To provide a steady stream of revenue into the future, especially important once you expect your investments to replace your regular income stream. And in a traditional investing environment provide somewhat of a hedge against falling equity markets (this has been debatable in recent years).

Fixed Income Possibilities:

So what about right now? In Canada short-term interest rates are officially on the rise. In the US, two Fed officials are now advocating a look to increase the short-term interest rates. Many believe that the US Fed fund rate will increase in the middle of 2011. Now although short term rates have or soon will increase, long-term rates have steadily fallen since the beginning of 2010. Last week, I read how Corporations are rushing to replace their long-term debt as the 10 and 20 year rates are at a 6 year low. The yield curve for fixed income products is flattening. `

So what does this mean for your retirement portfolio?

It could mean that your bond and other fixed income investments are valuable now! If you have seen an important increase in the value of your fixed income portfolio, this could be the time to sell part of it. First, you may want to consider first the income that you are giving up by selling these investments and what it will take to replace that income.

The goal of monetary policy in North America is to encourage sustainable economic growth while limiting inflation to reasonable levels (around 2%). To do this, central banks set the overnight lending rate and buy or sell bonds in primary market auctions. Often the amounts placed up for auction help determine the long-term yields. As the government would like to see a normal yield curve where interest rates increase with the duration (time to maturity) of the bonds, we will return to higher long-term rates in the future. Enough of Economics 101…

What To Do With Your Bonds

If your fixed income investments are valuable now (seen an increase in principal), you might want to consider to sell them while they are high. When all interest rates rise along a normal yield curve, the value of existing products will decrease with each passing day. You may want to reconsider replacing your existing fixed income positions with dividend producing preferred shares which might not be so affected by increasing interest rates and may also benefit from rising equity markets.

So what about your retirement portfolio? How steady is your fixed income portion?

This post has been written by Mike from Green Panda Treehouse. He is a financial planner and runs several blogs within his online company such as The Financial Blogger and The Dividend Guy. Mike is not endorsed or affiliated with LPL Financial.

photo credit: subewl

Taxable Build America Bonds (BABs) extended a recent run of outperformance relative to both U.S. Treasury bonds and Corporate bonds despite an uncertain future. Last week, strong investor demand helped the market digest one of the heavier weeks of new BABs issuance witnessed this year. Municipalities that issued BABs took advantage of low interest rates and strong investor demand for yield to issue new bonds. In addition to yield, relatively attractive valuations also boosted investor demand despite the uncertainty. We believe BABs have proven successful enough in financial markets that they can continue to be used by income-seeking investors with or without new legislation to extend the BABs program.

In July, BABs underperformed their taxable counterparts as the initial attempt by Congress to extend the BABs program beyond its current year-end 2010 expiration failed. The uncertainty caused yield differentials, or spreads, between BABs and Treasuries and Corporate bonds to widen. In August, BABs new issuance was the lowest since July 2009, the third month of existence for the BABs program.
Attractive valuations coupled with lower supply helped create a favorable backdrop for investor acceptance of last week’s new issuance despite future uncertainty.

Recent demand underscores the value investors find in BABs.

As Treasury yields declined through August, BABs were a destination for income-seeking investors. The inherent credit quality of municipal bonds likely provided comfort to investors seeking another source of longer-term bonds besides Treasuries or Corporate bonds. According to Moody’s data, Investment-Grade rated Municipal bonds have had an average 10-year cumulative default rate of 0.06% versus 2.50% for Investment-Grade Corporate bonds from 1970 through the end of 2010. The substantially lower default rate speaks
to the strong credit quality of municipal bonds. In our view, since BABs can only be issued for qualifying infrastructure purposes, this provides an extra level of security for investors.

Foreign investors have been among the biggest buyers of BABs as they seek to diversify existing holdings of Treasuries and Corporate bonds. Last week, the Federal Reserve (Fed) reported that foreign holdings of BABs increased 15% during the second quarter of 2010 after increasing 19% during the first quarter. Fed data on weekly Treasury holdings of foreign central banks held in custody at the Federal Reserve Bank of New York show an increase in Treasury purchases in July and August likely in response to European debt concerns. Although third quarter 2010 holdings data will not be released for some time, we believe BABs, like Treasuries, likely benefited from foreign demand during the current quarter as well as from lingering European debt concerns.

Congress returned to session last week but an extension of the BABs program beyond its current year-end 2010 expiration remains elusive. Proposed legislation of the BABs program was initially included alongside Financial Reform legislation but was stripped out of the final version. The latest attempt to extend legislation was introduced in the House in late July but was postponed due to the summer recess. The legislation called for a two-year extension of the BABs program but with a lowering of the subsidy paid back to municipalities from its current 35% down to 32%, and then 30%, sequentially, over the two years. Last week, Chairman of the Senate Finance Committee, Max Baucus, appeared to reach a compromise by introducing legislation to extend the BABs program for one year at a 32%
subsidy rate.

Extension of the BABs program prior to the November election is unlikely in our view.

Congress will adjourn on October 8, 2010 for the mid-term elections, leaving only a few days on the legislative calendar. More prominent issues such as tax legislation will likely take center stage and political posturing ahead of the elections will likely limit progress on most legislation. Should the year end without an extension in place, legislation could still be enacted in 2011 but new legislation is harder to accomplish than an extension of existing legislation. The non-partisan Congressional Budget Office (CBO) recently raised the cost estimate of the BABs program by $10 billion over ten years to a total of $36 billion. While the dollar amount is only a drop in the bucket of the overall budget deficit, it is nonetheless being scrutinized given the smooth functioning of the traditional tax-exempt municipal market.

Although considerable uncertainty remains, we believe a slightly greater probability exists in some form of extension occurring before year-end. BABs enjoy support not only from the Obama administration, but also from bond dealers and states have indicated strong support for an extension. The BABs program has proved an effective financing vehicle for municipal infrastructure projects.

Should the BABs program not get extended, BABs liquidity may be adversely affected. Bond dealers may choose to withdraw from participating in BABs trading without a steady flow of new issuance. A lack of liquidity could then lead to more volatile market swings. And BABs already possess above-average interest rate risk since over 90% of the sector consists of bonds maturing beyond ten years, according to Bond Buyer data. Failure to pass a BABs extension may put pressure on the prices of traditional tax-exempt long-term Municipal bonds, as BABs issuers turn back to the tax-exempt market for financing. Given the Fed data showing a shrinking market and still strong investor demand for tax-exempt bonds, we believe the expiration of the BABs program will pose little challenge to traditional taxfree
bonds.

However, investors seeking diversification from Treasuries and Corporate bonds or investors simply looking for a high-quality income-seeking fixed income alternative may mitigate potential liquidity risk. Given our benign view of interest rates over the intermediate term, attractive valuations, diversification, and income benefits, we believe the benefits offset the risks of potential reduced liquidity. We believe BABs can still be used as an effective income vehicle with or without new legislation.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
• High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
• The issuance of Build America Bonds (BAB) began in April of 2009. They were authorized by the ARRA economic stimulus of 2009 and can be issued for qualifying infrastructure projects. They are taxable municipal bonds and are considered a category of bonds.

photo credit: madiilafs

The reality of owning a small business in the United States today is that most companies will eventually, in the course of doing business, encounter a surety bond. If you’re one of the many companies today that does need a bond to conduct your business legally, you have probably wondered what the financial benefits are to the bonding process. And it would follow that you’ve also considered the legal and financial ramifications of not purchasing the necessary surety bonds for your company.

What is a Surety Bond?

Surety bonds represent an agreement between three parties: the party requiring the bond, the party purchasing and maintaining the bond, and the surety bond company who sells the bond. Typically, the entity who requires the bond is usually a governmental agency, and in addition to the federal government’s bond requirements, most states and localities have their own regulations which legislate bond coverages. Ultimately, the government’s insistence on bonding is generally to protect consumers against misconduct or non-performance on the part of the bonded company. If a consumer is harmed in the course of doing business with a bonded company, the party requiring the bond files a claim against it and, if the claim is valid, the surety bond company pays an agreed upon damage amount (up to the full value of the bond). Because the surety company pursues reimbursement from the bonded company, however, surety bonds are not a form of insurance but actually a form of credit.

Becoming bonded is a simple process and is generally inexpensive, particularly compared to insurance premiums and other small business expenses which can add up quickly. Bond amounts vary widely based on the type of bond that you need. For instance, when it comes to surety bonds in Illinois, a mortgage broker bond needs at least $20,000 while a collection agency needs a $25,000 bond to conduct business. Prices on these bonds can vary based on the dollar amount required and on the company’s credit status and financial history, which will be reviewed by the surety company at the time of purchase. If the company seeking the bond has a very poor credit history, they may not be able to purchase a bond at all, or may have to seek out a surety company that specializes in subpar credit bonds. Since surety bonds are a type of credit and rates are based on the financial health of the applicant, these bonds are at least twice as expensive as surety bonds for companies who have excellent credit.

Incentives of Surety Bond

While at first the prospect of a surety bond can seem potentially cumbersome and like one more hoop you need to jump through in order to conduct your business, rest assured that there are incentives to maintaining a valid bond. Most notably, incorporating your bonding status in your company’s advertisements will most likely increase your sales and business a great deal. In today’s difficult economy, consumers are becoming more and more aware of the importance of doing business with reputable, safe companies in order to maximize their gains from the transaction and minimize their loss, and becoming licensed and bonded represents a company’s willingness to work within the appropriate legal channels for their industry. Be sure to advertise your licensed and bonded status prominently in any promotional activity for your business, and mention it in any conversation you have with new clients and customers.

On the other hand, if you choose not to comply with legal requirements and purchase a bond, there are consequences, and some can be quite dire. Not maintaining the appropriate surety bonds can result in financial consequences first, namely fines from state, local, or federal government. Additionally, the lack of a surety bond can result in your business license being revoked or suspended which will effectively shut down your company until you’ve become bonded and can resume activity. Becoming bonded and resuming business can take up to several weeks due to the legwork required with getting paperwork where it needs to be, and providing documentation to all the parties who need it.

Are There Hidden Costs?

As we mentioned earlier, there’s also a rather hidden cost of failing to purchase a surety bond. Consumers use your bonding status as a sign of your company’s willingness to perform your job ethically and according to fair business practices. Choosing not to uphold your legal obligations to take out a surety bond demonstrates a poor attitude towards business in general and can be extremely detrimental to your public image.

Purchasing the required surety bonds for your business should really be a no-brainer. Bonds typically only cost a few hundred dollars, but the penalties for not carrying the required bonds can be well into the thousands. Don’t expose your business to risk and poor publicity. Save yourself some time, money, and sanity by getting bonded before you even begin doing business.

Bio: This is a guest post from Matt Bruns, a principal for SuretyBonds.com, the nationwide provider in surety bonds, as part of their surety bond education program.  Matt is not affiliate or endorsed by LPL Financial.

photo credit: lastlightphoto

August has so far been a very good month for high-quality bond investors but Mortgage-Backed Securities (MBS), issued by the government agencies Ginnie Mae, Fannie Mae, and Freddie Mac, have not participated in the latest leg of the bond market rally. Even after Friday’s sell-off in the bond market, the high-quality bond market, as measured by the Barclays Aggregate Bond Index, was up 0.7% for the month through last Friday August 27, 2010 led by Treasuries, which were up 1.2% according to Barclays Treasury Index data.

While MBS are up 5.5% year-to-date through the end of July, the MBS market is down 0.15% so far in August (through August 27), as measured by the Barclays Mortgaged-Backed Securities Index. Holders of these high-quality bonds are likely scratching their heads as to why MBS prices are unchanged and in many cases lower, in August. On average, the past two weeks, in particular, have witnessed slightly lower prices and higher yields despite the impressive strength exhibited by the Treasury market. The average MBS yield advantage, or spread, to comparable Treasuries has increased to the widest level in a year.

Refinancing on the Brain

A potential refinance wave, and not credit quality concerns, is pressuring MBS holders. Since MBS are refinanced at par, a higher level of refinancing increases the risk that premium price bonds may be redeemed at par. The MBS market typically adjusts fluidly to the level of refinancing but the speed of the recent decline in Treasury yields has caught the market off-guard.

In addition, 4.5% coupon MBS, which are mostly backed by 5% interest rate residential mortgages and comprise the largest segment of the MBS market, have just entered the refinance zone. Refinancing concerns have escalated over the past two weeks given the spike in the Mortgage Bankers Association Refinance Index.

Earlier in the month, two other factors played a minor role in MBS weakness but they were far less impactful in our view:

• ƒƒ Reports of a new loan forgiveness program emanating from Washington
• ƒƒ The future of the Government Sponsored Enterprises (GSEs)

More Government Programs

Speculation regarding a new principal forgiveness program from Washington for borrowers whose loan balance exceeds the value of their home caused mild market jitters. While such a program would indeed be problematic for bondholders, as it would likely entail investors of premium-priced bonds having their bonds redeemed at par (100), we view it as highly unlikely. The cost of such a program would be enormous and add to the fiscal deficit at a time when deficit scrutiny is at a fever pitch. Furthermore, the program might create a moral hazard by incentivizing borrowers who are underwater, but current on their loan payments, to stop making payments. This would not be a desirable outcome. We view any forgiveness program as highly unlikely.

photo credit: Wilson Loo

On August 17, the U.S. Treasury Department along with the U.S. Department of Housing and Urban Development (HUD) sponsored a conference on the future of housing finance with the intent to address the future of the GSEs, particularly Fannie Mae and Freddie Mac. The conference created modest uncertainty as market participants questioned whether it signaled the start of the government’s slow withdrawal of support for both Fannie Mae and Freddie Mac. However, the conference turned out to be mostly political theater with no solutions proposed. In our view, the only take away from the conference was the Obama Administration’s intent to maintain some sort of government guarantee, perhaps a partial guarantee similar to the role provided by a municipal bond insurer. The administration will convene again next February to discuss next steps. The housing finance problem is very complex and given the snail’s pace at which the issue is being addressed, we believe full government support for the GSEs may remain in place for years.

Underperformance On the Way

It is not uncommon for non-Treasury sectors to underperform Treasuries during flight-to-safety induced rallies, but refinance concerns are causing a particular disparity in August. If Treasury yields decline further or even stabilize at current levels, we expect MBS to continue to underperform within the high-grade bond market. The uncertainty over refinancing may likely persist over the near-term. Conversely, the now cheaper valuations will provide a buffer when Treasury yields eventually reverse course higher. For longer-term investors the cheaper valuations may provide an attractive entry point. Among high-grade bond sectors, we continue to prefer Investment-Grade Corporate Bonds to MBS, but MBS, despite near-term risks, remain our preference for investors focused solely on government bonds. Like all high-grade bond sectors, investors should be aware that the now lower level of yields implies lower returns going forward than what investors have been accustomed to in 2010.

IMPORTANT DISCLOSURES

• The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
• The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
• The Barclays Mortgage-Backed Securities Index includes 15- and 30-year fixed-rate securities backed by mortgage pools of the Government National Mortgage Association (GNMA), Federal Home Loan Mortgage Corporation (FHLMC), and Federal National Mortgage Association (FNMA).
• The Barclays Treasury Index is an unmanaged index of public debt obligations of the U.S. Treasury with a remaining maturity of one year or more. The index does not include t-bills (due to the maturity constraint), zero coupon bonds (Strips), or Treasury Inflation Protected Securities (TIPS).
• The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
• Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
• Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
• Past performance is no guarantee of future results.
• Mortgage-Backed Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
• GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
• The Mortgage Bankers Association of America Refinance Index covers all mortgage applications to refinance an existing mortgage. It is the best overall gauge of mortgage refinancing activity. The Refinance Index includes conventional and government refinances, regardless of product (FRM or ARM) or coupon rate refinanced into or out of.

photo credit: Diana Parkhouse