BondsOnline Advisor

Rates Rising? Contrarians Go Long

by Stephen Taub

When the Federal Reserve starts to raise rates, it's time to shorten your maturities, right?

Don't tell this to Mike Pietronico, who runs about $600 million in tax free assets for Evergreen Investments, including three municipal bond funds.

He says he's moving more of his dough to longer maturities, defined as 10 years or more. Why? "We will remain in a low interest rate environment," he asserts. "That's the story."

But wait. Didn't the Federal Reserve raise rates three times since the beginning of the summer as the economy showed signs of strengthening, and is likely to hike them some more before it is finished with its tightening mode?

And isn't it dangerous for investors to remain in bonds, especially long paper, when the Fed is in a tightening mode?

Not this time around. "That's fighting the last war," he asserts. "People want to continue to pull out the playbooks from 1994, or 1999."

This time, he insists, it's truly different. He says short-term maturities like two-year paper are most sensitive to the Fed increasing the overnight rate.

However, Pietronico asserts that when the Fed is raising rates to combat core inflation measuring a mere 1.8%, that is nothing but bullish for the long end of the market. He's figuring on a flattening of the yield curve. "They are setting up a big bond market rally," he insists.

But, aren't commodities like oil surging to new highs, or trading just off their highs, portending a sharp rise in costs for many companies?

Yes. The only problem is that in the otherwise low inflationary environment, most companies are unable to pass on these rising costs. So, they are eating them, causing profit margins to shrink.

To maximize his gains, Pietronico is avoiding the short-end of the curve-bonds with maturities up to seven years-the most sensitive to the increase in the overnight funds rate, he argues.

Rather, he has moved out to longer bonds, mostly in the 15-year range. He asserts this strategy will provide 90 percent of the expected total return of long bonds but with only 75 percent of the risk.

Why is 30-year paper riskier if he believes the yield curve will flatten in general? He says it's because the institutional and retail markets are less inclined to invest in this paper, so it is less liquid. "We think the long end has fewer inherent buyers, so it would decline in price faster," he adds.

Currently, 15-year AA municipal bonds are yielding, on average, 4.05 percent. This translates roughly to 6.75 percent on a taxable equivalent basis. The 30-year bond is yielding closer to 4.75 percent.

Looking out a year or so, he expects to earn the coupon and enjoy a "small amount of appreciation."

Pietronico certainly knows what he is talking about. According to Morningstar, his $455 million Evergreen Intermediate Municipal Bond fund has enjoyed a 7.6 percent annualized return over the past five years, outperforming his category by 1.89 percentage points - enormous for this type of fund and return. On a taxable adjusted basis, his five-year return works out to be closer to 10.3 percent.

During the same period, Treasuries rose 7.53 percent, high-yield bonds climbed 5.9 percent, and investment-grade corporate bonds surged 8.48 percent, according to Pietronico. At the same time, the Standard & Poor's 500 fell 2.6 percent while the Nasdaq index dropped 7.32 percent, according to Pietronico, who says he's quoting Lehman data.

So, how long does Pietronico expect the current scenario-rising short-term rates and falling long-term rates--to persist? The money manager figures sometime toward the end of next year, oil demand will come to a screeching halt due to much lower economic growth. "Rates and oil can't go up in tandem forever," he adds.

Then oil will go into a free-fall, which would change the current interest rate trends.

What happens when the Fed stops tightening and keeps short-term rates the same for a prolonged period? Short-term paper will appreciate (rates down). But, Pietronico concedes, "Then you want to be in the equity market."
 

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.