Morningstar Advisor - June/July 2010 - 31

ered gospel that the Fed will alter its “exceptionally low for an extended period” language well in advance of any actual tightening. There’s some uncertainty about how the market might react to that signal alone, of course. As PIMCO’s cash guru, Paul McCulley, stated earlier this year, “The most important book at the Fed right now is a thesaurus.” Shorter borrowing rates often move in lock step with the Fed’s moves, but longer-term Treasury yields can have minds of their own. The market’s confidence in the Fed’s ability to keep inflation under wraps matters a lot. Many observers agree that still-large output gaps and high unemployment should keep inflation muted in the near term. The Fed also has many more tools at its disposal today to combat inflation—including hiking its target rate, draining bank reserves, and selling bonds—than it has to fight deflation, and investors know it. Simple supply-and-demand dynamics also play a role, and on that front, the case for lowerfor-longer Treasury yields weakens. Although the final amount depends on the speed and magnitude of an economic recovery, many analysts predict that the Treasury will have to issue more than $2 trillion in debt by the end of 2010 ($1.9 trillion was issued in 2009). The Treasury has also announced its intention to shift new issuance away from short-term T-bills into longer-term notes and bonds, which could apply upward pressure on longer maturity yields. Regardless of the economy’s near-term fortunes, the mounting entitlements of Medicare and Social Security, coupled with an aging U.S. population, argue loudest for more Treasury issuance and higher yields in coming years. However yields behave in coming months, they have less room to fall and more room to rise. What makes the threat of rising yields so combustible today is the lack of income available to offset price declines. If you take the yields on the various Barclays Capital indexes that track different bond sectors

and divide those by the indexes’ duration, you get a rough estimate of how high yields would have to rise before price declines would wipe out offsetting income. The answer for investment-grade bond sectors is around 50 to 100 basis points (see table). Investors who have moved into short-term bond funds believing that these funds’ low durations will protect them from rising rates could also be in for a shock. Short-term yields are so minuscule that there’s very little income to cushion the blow when the Fed eventually starts tightening, making losses a real possibility.
Staying in the Game

Low All Around: Yield/duration estimates how far yields would have to rise for price declines to wipe out returns from income.
Yield % Duration Yield/ Duration

Barclays US Aggregate

3.4

4.7

0.71

US Agg 1–3 Year US Agg 10+ Years US Treasury US Treasury 1–3 Years US Treasury 10–20 Years US Corporate CMBS ABS US MBS US Corp High Yield BB US Corp High Yield B
Barclays Emerging Markets Barclays G-6
Data as of April 30, 2010.

1.4 5.1 2.3 1.0 4.1 4.3 5.2 2.4 4.0 6.9 7.7
6.0

1.9 11.7 5.2 2.0 10.0 6.5 4.0 3.3 3.7
4.3

0.76 0.44 0.44 0.49 0.41 0.66 1.29 0.73 1.07
1.89

If bond investors understand just how rigged the game is, they may approach their bond allocations with a bit more trepidation. But judging by the billions that have continued to flow into bond funds so far in 2010, it seems that investors don’t appreciate that fixed income faces an uphill battle in coming years. Those who are chasing bond returns of the past decade should note that bonds no longer enjoy the income advantage or the tailwind of declining rates that propelled them over that period. Cash investors who’ve become impatient with near-zero money market yields may also be turning a blind eye to the risks they’re taking on for very little reward. Bonds still have a place in long-term asset allocations, however. Many factors come in to play when deciding whether to buy individual bonds or bond funds, but in a rising-rate environment, owning bond funds may have some advantages. When market rates rise, bond-fund yields adjust upward with a lag, as managers put the portfolio’s coupon payments to work at higher prevailing yields and trade out of less-price-sensitive shorter maturities into higher-yielding alternatives. Investors who buy individual bonds today are locking in yields near all-time lows. The peace of mind they get from not having to watch their funds’ net asset value decline is an illusion that masks the opportunity cost they’re paying for the privilege of tying money up in lower-yielding securities.

Barclays US Corp High Yield Idx 8.1

5.0 3.9
6.5

1.38 1.97
0.92

1.8

7.0

0.25

While no bond manager possesses a panacea for rising rates, the typical manager has many tools to protect his or her portfolios. Not all managers agree on the best way to prepare for a rising interest-rate environment today, though, so it’s critical to take a closer look at how they’re positioning their funds to fully understand the scenarios under which your investment will thrive or falter. Out of the diversified bond managers we survey, it appears that many are currently playing variations on one of two themes: The Gross or The Fuss.
The Gross

Some managers view the economy’s recovery as tentative, and they’re paring back exposure to the credit-sensitive bond sectors that have rallied over the past year. As a result, those with a narrowly focused mandate may hold sizable exposures to bonds backed by the U.S. government. While these sectors come with minimal credit risk, they can be highly sensitive to rising rates. Mortgages in

MorningstarAdvisor.com 31

http://www.MorningstarAdvisor.com

Morningstar Advisor - June/July 2010

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2010