Fixed Income Strategies with Historically Low Interest Rates

Thursday, September 1, 2011

As I write this article, the 2 Year Treasury Note is yielding 0.19%, similar maturity AA municipal bonds are yielding 0.40% and AA corporate bonds yield approximately 0.45%. In addition to these historically low rates the FED is on record as saying, “They expect. . . exceptionally low levels for the federal funds rate at least through mid-2013”. The market is anticipating and in our opinion this language is indicating that this indicating, two year period of low rates is probably a minimum time frame and low rates for three to five years or longer are very possible.

In this environment, how do investors position their bond portfolios to provide some reasonable level of returns without taking significant credit or interest rate risk? For funds above and beyond one’s daily liquidity needs, we continue to focus our buying on intermediate maturity bonds, primarily in the 4-8 year area of the yield curve. This allows for current income in the range of 2.00% to 3.00% for AA corporate bonds or 1.00% to 2.00% for AA municipal bonds. While these returns appear modest, it allows for returns in line with current inflation rates without subjecting a bond portfolio to significant credit or interest rate risk.
As readers of our quarterly letters are aware, another sector of the bond market we currently find appealing are sovereign bonds in certain developed countries around the world (see our website for more details and thoughts on our sovereign bond program). We have been actively deploying this program since early 2011, and even though rates have fallen, we still believe this strategy still has value. Unfortunately, we continue to believe a weak U.S. dollar versus certain currencies is likely given the fiscal challenges in the Unites State and its continued reluctance to address these issues in a meaningful manner.
Ancora Advisors’ hesitancy to recommend either long maturity bonds or lower credit quality bonds stems from our concern about the potential for significantly higher rates of inflation in coming years. While inflation is likely to remain modest as long as economic growth here and around the world remains in the low single digits, the continued printing of paper money here and in Western Europe threatens to reignite inflationary pressures in coming years, and in turn significantly increase interest rates and drive down the prices of longer maturity bonds.
Besides the potential of lower bond prices in the future because of higher interest rates, we are also concerned that lower credit quality bonds could see lower prices based on wider credit quality spreads. Currently, lower credit quality bonds trade at historically tight yield spreads to treasuries and any reversal of these historically tight credit spreads could cause significant price erosion for lower credit quality corporate bonds. As an example, during the weak equity markets of the first two weeks of August, the Vanguard High Yield Index Bond Fund was down over 4%. For those portfolios which are either currently underweighted in equities and/or willing to assume the inherent volatility of equities, adding to one’s equity exposure, especially in stocks with attractive dividend yields (2%-3% or higher), modest dividend payout ratios, and a history of growing dividends, may offer an alternative to historically low bond yields. (See our website for a recent article that discusses high dividend paying stocks and how they may be utilized in an investment portfolio.)
In conclusion, for a number of years we have been advocating an emphasis on good credit quality, intermediate maturity bonds as a safe haven during this period of extremely low interest rates. As previously stated, we prefer individual bonds to bond funds for those portfolios that can be adequately diversified. Bond funds currently offer low yields, extremely limited upward price potential, and the potential for significant price declines if interest rates increase a few years down the road. However, bond funds would be preferable to individual bonds in those sectors where building a properly diversified portfolio of individual bonds would be cost prohibitive given the size of the portfolio. These sectors include high yield bonds (as stated above we would only hold modest exposure to this sector), emerging market bonds, and other specialty sectors.