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Bond Strategy? Red Light.

By: Jeff Goble

Interest rates are so unbelievably low at present that making a reasonable plan to invest your excess cash and maturing/called securities can be a frustrating, almost depressing activity. With many high-yielding bonds rolling off now, there are simply few replacement options in my opinion that do not involve accepting a significant risk trade-off of some type. Because of slack loan demand, record-high bond prices and abundant cash on the sidelines, this may turn out to be one of the most dangerous bond markets in our banking careers.

In the past, when these difficult market conditions have arisen, it has always paid to try to remove emotion as much as possible by returning to a bond strategy playbook for guidance. Several years ago, I was searching for a mechanical tool to remove market emotion and help guide day-to-day investment decisions throughout the interest rate cycles.

I knew that the five main variables for us as bond investors are: the available yields in the market; the average yield and maturity/duration of your portfolio (your cost basis); the shape of the yield curve; the amount of cash you have to invest; and the overall portfolio’s gain/loss position. How can all of these market clues be connected to help us know what to do?

While daydreaming one day at a stoplight in an intersection, the model at right appeared in my mind. I call it the stoplight strategy for obvious reasons and it has served as a handy and reliable guide for me for many years. Perhaps it can help you, too.

The main advantage of using a system like this is that it gives you confidence to follow a more-disciplined program for investing your cash as interest rates and the economy go up and down. I often see intense NFL football coaches on the sidelines on TV studying their plastic charts that help determine the next football play to be called given the yardage and down situation.  It is pretty clear they are simply trying to find a system to increase their odds of being right given the often-stressful game conditions that exist.

The stoplight strategy can help you more consistently call the right investment play by simply playing the averages and recognizing the economic conditions presented to you at the time. You can see in the chart that the strategy is calling our attention to the extremely large bond gains we now face, low reinvestment yields and steep yield curve. While it is difficult to stay short in this market, the system is strongly suggesting this move.

The next question is what “short” really means as the fed funds and Fed excess balance accounts are all paying 0.25 percent or lower. In addition, most banks already have tons of liquidity positioned in 2011 and 2012 so staying short adds even more reinvestment risk if interest rates stay down for several years. What are the chances of this?

When there is lots of uncertainty about the economy and interest rates are at historical lows, it has always paid to think about your portfolio over the long term, be patient and accept less. The four most expensive words on Wall Street have always been … this time is different.

Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble(at)umb.com.

Copyright © October 2010 BankNews Media


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