BondsOnline Advisor

Lowering Expectations

by Stephen Taub

Wall Street is bearish on bonds.

Acknowledging that the Fed is now in a longer-term tightening mode, they are preparing their clients for modest returns, at best, in 2005.

Many are recommending an underweight position in fixed-income securities and a shortening of duration.

But, didn't we hear the death knell for good returns last year at this time, only to see many fixed-income markets post pretty impressive numbers? Yes.

But, last year the Fed didn't start tightening until June and long-term rates actually fell afterwards. Now spreads are so tight, the pros don't think there is much more room for large gains. Especially given that experts, like the folks at UBS expect the Fed to raise rates by 175 basis points during 2005 "amid a self-sustaining economic recovery and moderately higher inflation."

UBS' economics group is calling for the 10-year note yield to approach the 5% level by year-end from current levels of roughly 4.25%.

The UBS Wealth Management Fixed Income Strategy group calculates a fair value target above 5% for the 10-year note yield, given current estimates for growth and inflation.

"As U.S. growth remains steady and core inflation rises in 2005, the Fed is likely to continue raising interest rates at a "measured" pace," it adds.

As a result, the firm recommends a "significant underweight in bonds," a duration underweight to mitigate principal erosion and a barbelled yield curve allocation in anticipation of a flattening yield curve during 2005.

More specifically, it says treasury and agency note returns "are likely to be poor."

So, its asset allocators are actually recommending an overweight position in cash in anticipation of a potential improvement in valuation of riskier asset classes.

PIMCO managing director Bill Gross mostly agrees with UBS. He asserts that "2005 will witness a changing environment in some way —slower global growth, somewhat higher short-term rates."

He says the dominant moneymaking themes in the bond market should be the following: 1) The Fed stays relatively low, 2) China revalues its currency, 3) Spread products (mortgage-backed securities, asset-backed securities) underperform, 4) Europe remains sick, and 5) Cash is Prince.

"Our belief that the Fed stays relatively low (½% real short rates or less) is a long-standing one and based on several secular and cyclical observations," he states. "Since the primary global economic problem is a lack of what is known as aggregate demand, central banks everywhere will continue to remedy the affliction by keeping real short rates low."

He says low short yields help stimulate demand by creating gradually rising inflation and nurturing capital gains in equity, real estate and bond markets. "Whether the Fed stops at 2½, 2¾, or 3½% is really more of a debate as to the future of U.S. inflation, not the fact that real short rates must stay down for a long, long time," he adds.

Gross elaborates that spreads are so slim that the capital gains inherent in spread narrowing are no longer likely and the yield spreads offer little compensation for future risks of an economic or geopolitical nature.

He adds that with the Euro soaring and Euroland inflation moving down not up, German Bunds remain a better alternative than U.S. Treasuries despite their 50 basis points lower yields. "They may not make our year in '05 like they did in '04, but there's more life left in that old German mare," he adds.

At the same time, he agrees with the folks at UBS that, all things considered, cash is not looking too badly this year. "It seems difficult to imagine how many if any fixed income maturities/sectors can outperform good old cash in 2005," Gross concedes.

"The successful 2005 bond strategy therefore, will likely be to avoid long duration, avoid spread product and to flock to the stability of cash, TIPS, and foreign bonds issued by strong currency countries in an openly reflationary world," Gross adds. "If so, bond market returns of 3-4% for the year may be all an investor can rationally expect, and if those Asian investors flee for the exits then longer duration portfolios might even wind up in the red."

Merrill Lynch, on the other hand, is more hopeful. It concedes its low-interest-rate, low-volatility forecast for the US and Europe runs counter to the consensus, which expects higher yields and recommends defensive investment strategies.

Indeed, it is urging its clients to accept what the title of its most recent bond report calls, the "New Normal."

This is defined as a period of "stable global interest rates, slowing growth and low inflation in the US and Europe," which will likely result in a low-volatility environment for bonds in 2005.

Merrill adds that taking advantage of rising interest rates in Japan and stabilizing interest rates in Europe and the US will be keys to the strong performance of government bonds investments in 2005.

"Indeed, the primary risk to our view comes in the form of an inflation shock from Asia that would precipitate a rise in US and Euro bond yields," it adds.

Merrill adds: "Understanding this trend and recognizing that it differs from years past, will be key to enhancing the performance of bond portfolios in 2005."
 

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.