Morningstar Advisor - August/September 2013 - (Page 46)

Spotlight Exhibit 4 The Five-Year, Five-Year Forward Inflation Breakeven Rate % 3.0 2.5 2.0 Inﬂation expectations sliding as market begins to price in higher probability of Fed tapering in the near term. 1.5 1.0 0.5 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 its lowest levels historically. As long as the Fed continues its $85 billion per month asset-purchase program, we think that the yield of the 10-year Treasury will remain in a range of 1.75% to 2.25%. However, we caution investors that once the Fed announces its intention to taper, interest rates will likely rise 100 to 150 basis points in a relatively short period of time. After the release of the Federal Open Market Committee statement after the June meeting, the Treasury market is pricing in a higher probability that the Fed will reduce its asset-purchase program sooner rather than later. Investors are selling longer-dated bonds accordingly. Part of the reasoning is that every bond trader and fixed-income portfolio manager in the world will try to front run the rise in interest rates, likely compounding how quickly and how far rates will rise. The question bond investors need to ask themselves is, who in their right mind would want to buy long-duration securities right now? The Fed, which has been the single largest buyer of Treasury bonds, is not concerned about gains and losses and is likely going to start reducing its purchases this fall. While Treasury bonds may experience relief rallies over the near term, we think that as long as the market believes the Fed will begin to taper its purchases this fall, interest rates will likely continue to rise. 46 Morningstar Advisor August/September 2013 In basic terms, the Fed’s asset purchases have not been made for investment purposes, but for economic reasons—to push interest rates down below where they would otherwise belong. Once the Fed is no longer manipulating rates, we expect long-term rates to normalize toward historical averages. The yield on the 10-year Treasury bond has averaged 245 basis points over a rolling, three-month average of the inflation rate (Exhibit 3). Even with inflation registering only 1% in June, on a normalized basis, the 10-year would yield about 3.5%. Whether the Fed begins to reduce its asset-purchase program in the near term or medium term, we expect interest rates will continue to rise (barring a significant shock to the e conomy) toward its average real return over inflation. As interest rates rise, it reduces that principal value that a homebuyer can afford for an equal monthly payment and increases the monthly payments for auto loans. If interest rates rise too much, too quickly, it could impair the nascent housing recovery or trim the number of new auto sales, both of which have helped the economy rebound. Johnson, Morningstar’s economic researcher, argues that the market’s worries about higher rates are misplaced. In his opinion, the economy can easily survive rates as high as 3.5%. He also says that higher rates are not an entirely bad thing for the economy. Higher rates, for example, increase retirees’ incomes. The risk to his view, as we mentioned earlier, is that consumer spending, which is one of the main drivers of economic growth, is pressured as incomes stagnate. While we expect interest rates will quickly normalize, we are not overly concerned that the rise in rates will overshoot too much from historical averages. The market-implied inflation expectation is quickly sliding. Treasury bonds and Treasury Inflation-Protected Securities are pricing in a higher probability that the Federal Reserve will begin to taper its asset-purchase program in the near term. Our preferred measure of inflation expectations is a figure called the “five-year, five-year forward” inflation break-even rate (Exhibit 4). This is what the market expects inflation to be, starting in five years and the subsequent five years (2018 to 2023). This rate rose as high as 3% in September 2012 after the FOMC announced its asset-purchase program, but has since decreased to 2.37%. Although it is still slightly above the 2.14% average since 1998, the rate is below the 2.45% average since the beginning of 2010, when fixed-income markets began to normalize after the crisis. We’re Neutral, for Now Although credit spreads on corporate bonds are becoming more attractive at wider levels, we continue to think corporate-bond credit spreads are within the range of being fairly valued (albeit at the high end of the range). Since we changed our view on the corporate bond market to neutral from overweight last fall, the average credit spread has ranged between 130 basis points and 155, averaging 140. We would consider moving to an overweight opinion if credit spreads continue to widen from here and if there are no changes to our underlying fundamental and economic assumptions. K Dave Sekera, CFA, is a bond strategist with Morningstar.

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2013

Morningstar Advisor - August/September 2013
Contents
Contributors
Letter From the Editor
Under Pressure
Has Your View of Bonds Recently Changed?
The Simple Life Cuts a Path to Prosperity
How Extended Is Your Bond Fund?
A Bond Contrarian Scours the Globe for Value
Investments á la Carte
Investment Briefs
Bond Market Behemoths
Shopping in the Digital Age
Shopping in the Digital Age
Diverse Crowd
Motor City Meltdown
Bond Convergence
Corporates Are Fairly Valued, but Opportunities Will Arise
A Legend Still Pines for the Good Fight
Greener Pastures
Forecasting Market Bubbles and Crashes
Forecasting Market Bubbles and Crashes
Home-Court Advantage
Overcoming Technophobia
These Funds Are Counting on Undervalued Sectors
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
What Price Advice?

Morningstar Advisor - August/September 2013