Bullish on Bonds

Terry Flanagan

Recent turbulence in the fixed income markets is being viewed as an overreaction to the Federal Reserve’s plan to begin “tapering” its quantitative easing program later this year provided unemployment continues to trend lower.

“The sell-off in the credit-related sectors was fueled by a shift in market technicals, not fundamentals, resulting in market dislocations that have created long-term value opportunities,” Michael Lillard, chief investment officer at Prudential Fixed Income, said at a press briefing this week. “We expect interest rates to remain relatively low from a historical perspective, and while they may drift somewhat higher over time, the extreme volatility we’ve witnessed recently is unlikely to persist.”

The perceived overreaction to Fed policy statements means “that as we look forward to the second half of 2014, fixed income is seen as quite attractive,” said Lillard. “The core of the Fed message is that quantitative easing is an emergency tool, and as unemployment falls and a housing recovery takes place, they will begin to taper. However, unemployment is still 7.6% versus a Fed target of 5.5%. Other measures of employment, such as labor participation rate and employment to population ratios are also below the Fed target.”

Immediate analysis of the past 6 weeks’ market action argues that in late April bond markets were approaching a tipping point, according to Pimco’s Bill Gross.

“Yields were too low, prices too high, both for investors’ and the economy’s own good,” he said in a blog. “The Fed’s Jeremy Stein had written a research paper outlining the risk. I, in fact, had written a March Investment Outlook outlining Governor Stein’s paper, and to be fair, Pimco had been warning of high seas for what seems like an eternity. ‘Never,” I tweeted, ‘have investors reached so high for so little return. Never have investors stooped so low for so much risk.’”

The risk, said Gross, was not only in narrow credit spreads and emerging market debt/equity markets but at the heart of the credit system itself: U.S. Treasuries.

Bullish signals on bonds are also coming from abroad, “as Europe is struggling to come out of recession, and emerging market growth is slowing,” Lillard said.

Over the past month, interest rates have shot up 100 basis points in U.S. Treasuries, which combined with an appreciation of the dollar, which keeps U.S. exports low, has had a dampening effect on the economy.

“Given the slack in the labor force and the low inflation rate, the Fed will keep money market rates at zero until 2015,” said Lillard.

Real buying opportunities exist in credit sectors, where spreads have widened dramatically as investors have exited bond funds. “Spreads are widening in response to fears of a strong economic recovery, yields have overreacted, and as a result, we are long duration in our portfolio,” Lillard said. “Default rates are low, and balance sheets are strong. You can get strong BB rated bonds at spreads of 300 bps, which is an exceptional opportunity.”

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