I cannot remember a more frustrating confluence of economic and market extremes than we as bond investors face for 2010. There have been many similar “nothing seems to make sense” markets in the past (e.g.1993, 1998, 2001) but last year was perhaps the worst combination of supply and demand extremes since WWII.
First, the Fed essentially lowered the fed funds rate to zero, thus driving bond prices absolutely through the roof. There were two periods within the last 15 months where short-term T-bill yields actually posted negative yields. We had not seen this level of panic since the 1930s, and the bond price bubble created an opportunity for many banks to take advantage of the record prices to book bond gains.
Next, the Fed announced a historic buyback of $300 billion in Treasuries and $1.4 trillion in agency/mortgage-backed securities as part of its massive quantitative easing plan targeted to jumpstart housing. In addition, there were estimates last year that the government purchased as much as 75 percent of all new residential mortgages created, thus severely limiting the packaging of mortgage securities for us to buy from FNMA, FHLMC and GNMA.
For many banks, it is becoming more difficult to find enough quality issues to replace their monthly bond maturities, let alone invest excess cash. Take note of this scarcity, as it is rare and usually foreshadows a change of direction in the market, the future supply of new issues, and the direction of the economy down the road. I wish I knew the order and timing.
Lastly, the dollar fell for much of the year, thus encouraging our Japanese and Chinese trading partners to step up their purchases of U.S. bonds in order to prevent their own currencies from rising too much, which could affect their sales of goods to Wal-Mart. In many of the enormous Treasury bond auctions held late last year, foreign investors purchased more than half of the total issue. The U.S. debt total as a percentage of GDP is now the highest since the 1950s. What happens to the bond market when the Fed starts to unwind its inflated balance sheet and finally deals with our huge debt?
“There are few things more expensive than reaching for additional yield.”
Today’s bond market offers higher yields only at the risk of accepting weaker or more complex structures, longer maturities, additional call risk or increased credit risk. As a general rule, the more words or features in the security description, the worse the bond’s attractiveness.
In conclusion, interest rates are at historic lows now and the supply of good quality issues is unusually low. You can weather this difficult market, however, and I would like to offer a few friendly suggestions that might help:
- Be careful if you are thinking about amending your investment policy now for your board to try something new to earn higher yields.
- Thoroughly evaluate what happens to the market value of a bond purchase you are considering if interest rates were to rise dramatically. It is easy to ignore this important practice now to boost current income.
- Do your best to maintain your security mix if it currently matches your philosophy and balance sheet, even if it means less income this year.
- Carefully evaluate your bond portfolio’s existing cash flows over the next 12–24 months, as most banks have more than enough liquidity positioned in the next two years. The term of bond you choose to buy now is more important than its yield, in my opinion.
- History shows that extreme low points in interest rates have not lasted very long, and are often followed by dramatic upward changes as the economy recovers and the Fed reverses monetary gears.
From my view, now is the best time in about 50 years to be patient and willing to follow the classic, time-tested investment adage: “As investors, where we are rewarded the least … we will eventually benefit the most.”
Best wishes for a prosperous 2010 and a special thanks to BankNews for the privilege of writing in this space for the past 20 years. I hope I have helped you sleep a little better at night.
Jeff Goble is executive vice president and managing director, investment banking, at UMB Bank, n.a., Kansas City. His email address is Jeffrey.Goble@umb.com.
Copyright © January 2010 BankNews Publications