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Bond Strategists Make Adjustments and Cut Their Risk

by Stephen Taub

Seven rate hikes after the Federal Reserve began tightening, market strategists are starting to shift their priorities.

UBS said in early April that for the first time in more than a year it recommends that investors move their Treasury positions to a market weight from an underweight position.

At the same time, UBS and a number of other strategists are losing their interest in junk bonds.

"There is clearly a heightened level of uncertainty and greater attention to risk within financial markets overall," the investment bank recently told its clients. "Moreover, the increased concern regarding risk in financial markets may have less to do with a declining appetite for risk and more to do with an absence of value across asset classes."

It adds that investors may be more concerned with risk not solely because risk levels themselves have increased, but because the still low compensation that investors receive for risk-based assets means the margin for error for owning financial assets is even smaller.

Sure, interest rates have moved considerably higher since they posted near-historical lows in mid-2003. Yet, yields are still below fair-value and are expected to move higher over the balance of 2005, UBS adds.

"With the Fed still engaged in lifting the funds rate, inflation expectations moving higher, continued fiscal imbalances, and still strong economic activity, our economics group is still calling for a 5% 10-year note yield by the end of 2005," it notes. "Although continued heavy foreign central bank participation could help to keep bond prices supported (and rates low), it is our view that cyclical fundamentals will drive yields higher over the course of the year."

The current low yield environment creates other risks. For example, it encourages investors to move out along the maturity spectrum to pick up yield, and coupon income is less likely to offset price declines, UBS adds.

Meanwhile, the yield curve has flattened considerably. For example, from its peak of 275 basis points in mid-2003, the yield differential between two-year and 10-year treasury notes has narrowed to roughly 75 basis points. This means bond investors are not rewarded much for venturing out on the coupon curve.

"In an expected rising rate environment, we recommend that investors pare back exposure to longer duration debt securities, which are becoming increasingly expensive relative to shorter duration parts of the curve," UBS counsels.

Meanwhile, yield spreads on corporate debt securities narrowed sharply on expectations for improved credit conditions (General Motors excepted), lower incidence of default, rising profit margins and reduced debt leverage. "This collapse in yield spreads would suggest that investors no longer have as much margin for error in the event that corporate credit conditions were to worsen materially," the investment bank adds.

The upshot: For the first time in over a year, UBS said it is increasing its allocation to treasuries by moving to a market weight allocation from an underweight. "Based on our view that risks have increased while risk premiums in spread product (read - high yield bonds) have not, we are electing to tilt our portfolio allocation to a more defensive posture," it explains.

Relatedly, UBS it is reducing its allocation to the high yield market to underweight from market weight. "In our view, the credit cycle may now be poised for a turn," it elaborates. "Our analysis suggests that credit quality in the corporate market is probably as good as it will be this cycle and thus the same may be true of credit spreads."

It also recommends a modest overweight in mortgage-backed securities and municipals, market weight in corporates and TIPs, modest underweight in agencies and underweight in preferred stocks.

"High quality bonds, and especially those with inflationary protection, remain the bond market's best bet," Bill Gross, manager director of bond investment giant Pimco, recently told his clients.

The reason: PIMCO expects real yields to stay low. It figures all asset classes will compress to provide 2-3 percent real and 5-plus percent nominal returns over long periods of time.

Meanwhile, Andrew Clark, Senior Research Analyst for Lipper Fund Intelligence, recently recommended halving exposure to high yield bonds to 12.5% and halving exposure to BBB bonds, to 12.5%.

At the same time, he doubled his exposure to 10% each for TIPs and short-term US Treasurys. He also cut his position in emerging market debt to 5% from 10%.

The reasons for these changes: Clark says Lipper did a study where it took the Treasury, corporate and muni yield curves and assumed 25 basis points moves every Fed meeting between now and the end of the year (4.25% funds rate and 5% 10-year Treasury yield). Lipper rolled down all the maturities as time went by and it calculated a simple total return over a one-year holding period.

The result: The returns all along the yield curve out to about 10 years is about the same. "This told us that staying intermediate in length, somewhere in the belly of the curve, is a good place to be," he explains.

He adds: "We do note that the volatility in the bond market is picking up."
 

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Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.