Figuring Out the Bond Market When History Doesn't Apply

Two weeks ago, I was preparing nifty-looking charts to offer some perspective on our economic situation relative to past cycles. However, the world has changed in innumerable ways, and comparisons to the past might not be that useful. For example, there's increased potential for U.S. military engagement in the Middle East, yet oil prices aren't skyrocketing. This contrasts markedly with the months before the Gulf War, as crude jumped from around $20 per barrel to around $40 in August 1990.

While it's difficult to compare this environment to the past, it's also hard to make judgments about the future. Of course, the virtual shutdown of significant parts of the economy for two weeks has had a negative impact on the economy. That's a given. The key questions are how deep it will be and how quickly and strongly we will rebound.

It's impossible to respond to those questions now. The answers will partly depend on the global response to terrorism and on whether domestic travel patterns pick up. These are two factors without much historical precedent. While predicting the economy is now even harder than usual, we can try to figure out what outcomes markets are discounting and, from that, get an idea of what the potential risks and returns are.

Over the past week on the RealMoney Columnist Conversation, I've tried to analyze some of the factors impacting the bond market. Now is a good time to look at those factors cohesively and then analyze what they might mean for some of the broader sectors of the fixed-income arena. I'll start by looking at the short and long ends of the Treasury curves and then move on to some of the bigger spread sectors.

The Short and Long Ends

Short-term Treasury yields, spurred by flight-to-quality buying and the lowering of short rates by the Federal Reserve , fell to extremely low levels. In the days immediately after the attacks, long-term Treasury yields had also declined.

Last Tuesday, I mentioned before the market opened that I was considering taking some gains on my longer Treasuries and moving into something shorter. That thought was immediately followed by a sharp selloff, as insurance-company selling began to overwhelm a very thinly traded market. The forced nature of this selling seemed evident to me, because longer bonds weren't bolstered by the sharp declines of the equity market.

By Wednesday, the rise in long yields had become so pronounced that, instead of selling, I started adding a small amount to my longer Treasury positions. Only in a handful of occasions in my career have I changed my buy/sell thinking that quickly, and all were in response to extremely sharp market movements.

With short and long yields moving in opposite directions, the yield curve has steepened dramatically.

Ten-Year Less Two-Year Treasury Spread In basis points

Source: St. Louis Federal Reserve Board

Last spring, I started moving from shorter Treasuries to longer ones as the curve steepened, moving from a zero weighting to the middle of my target range. That switch worked until this month; I now would've been better off if I had waited. But almost all of the recent steepening has been due to short-term yields declining; most of my longer purchases are still above water despite last week's losses.

The disparity between short and long yields presents some interesting choices for investors. While it's hard to predict where the economy will go in the next few quarters, it appears that different ends of the curve are anticipating different outcomes.

What This Means

The pricing of the long end now incorporates at least some combination of only a brief economic pause, greater Treasury issuance and potential for higher inflation from the aggressive Fed easing. Yields on the short end incorporate some combination of protracted economic weakness, the fed funds rate at a low level for an extended period, the potential for lower inflation due to a soft economy and the prospect for increased "safe-haven" demand to offset the increased Treasury issuance, which will occur not only in the long end, but across the curve.

So, if the economy rebounds, shorter maturities could be hit harder than longer maturities. If the economy remains sluggish, longer maturities may gain, while shorter issues might not have much juice left.

I'm now slightly above the midpoint of my target weighting for long Treasuries, and I plan to increase that if the curve steepens further on any more insurance-company selling.

Other Sectors

Corporate bonds, both investment-grade and high-yield, present a dilemma for me. This two-week period has been one of the worst relative performance periods for them, and spreads to Treasuries have widened significantly. I'd normally view this as a buying opportunity, and I noted Tuesday that I was thinking about adding to them.

But reasons for the poor performance need to be examined carefully before making a decision. I see two major reasons for the underperformance: insurance-company selling, which I think makes corporates more attractive, and the potential for credit deterioration, which concerns me.

Current spread levels reflect the possibility of some worsening of corporate credit quality. So, for someone without corporate-bond exposure, now would be a good time to begin scaling in. Given that I'm already overweighted in corporates (a little above market-weighted in investment-grade, along with some high-yield), I'd like to either see even wider spreads or get some indication that credit downgrades will not be severe before adding more.

The prospect of increased Treasury issuance has the potential to "crowd out" corporate-bond issuance. Lower corporate issuance could allow the sector to outperform Treasuries, which is a reason why I'm sticking with my holdings. While corporates as a whole would benefit, this scenario could hurt weaker companies with bad balance sheets. When I first recommended high-yield funds, I cautioned that investors should seek out managers with a history of avoiding problem sectors, and this advice still holds.

The mortgage-backed sector of the market has done well, which is to be expected when long yields rise. Mortgage yields have actually fallen this month. Given the tightening of spreads in this sector, I wouldn't be a buyer now and would prefer Treasuries to mortgages. If Treasury yields decline, I would expect spreads to widen back out and would then consider buying mortgages. If Treasury yields continue to rise and spreads tighten more, I would consider selling my small mortgage positions and swapping into Treasuries.

I've written before that it may not make sense to mimic me; individuals need to take their own financial situation and risk tolerance into account when making decisions. However, you can use this as a guide to help figure out where the potential risks and returns lie.