This column was originally published on RealMoney. It's being republished as a bonus for TheStreet.com readers.
It's time for investors to disassemble those laddered fixed-income portfolios.
For the past 20 years or so, most fixed-income strategists, including myself, have advised individual investors to create a laddered portfolio of fixed-income securities in their retirement accounts. With a laddered portfolio, the investor buys securities at different maturities (the ladder) at future dates, when the return of principal is most likely to meet the needs of the investor during the retirement years.
This was a favored strategy of mine when I helped advise individual investors as a U.S. Treasury strategist at Smith Barney in the first half of the 1990s. Given the decline in yields since then, I say it's time to book the long-term profits by disassembling the ladder.
A longer-term trend toward higher yields lends support to my strategy recommendation.
The Five-Year's Cue
When I look at the direction of U.S. Treasury yields, I focus on the five-year note. The weekly chart below clearly shows that the yield on the five-year bottomed in June 2003 as the
Federal Open Market Committee
pushed the federal funds rate to 1.00%.
A Clear Low
Source: GMC Reports
The five-year yield now is rising above the 200-week simple moving average at 3.520%. The decline in yields since March 23 provides an opportunity to sell at lower yields, while the FOMC continues to raise short-term rates at its stated "measured pace." The FOMC has raised the federal funds rate by 25 basis points at each of eight meetings, beginning June 30, 2004. This has taken the funds rate to 3.00% from 1.00%. The next (two-day) FOMC meeting is June 29 and 30; a rate hike to 3.25% is likely to be announced at 2:15 p.m. EDT on June 30.
There is further evidence that Treasury yields are on the rise in the daily chart for the five-year yield. This chart shows that the yield on the five-year rose above its 200-day moving average on Nov. 5, 2004. Tests of this rising trend for yields failed in December 2004 and February 2005. At this time, the 200-day moving average provides strong resistance to the yield falling below 3.672%.
Resistance at 3.672%
Source: GMC Reports
Steer Clear of Corporates
If you agree that yields will be rising again, you also should avoid corporate bonds.
Corporate bonds are priced off and trade off the U.S. Treasury yield curve at spreads based upon the creditworthiness of the company issuing the bond. To illustrate my point, I will focus on high-yield corporate bonds, known as junk bonds, with a 10-year maturity.
In June 2003, with the 10-year at a yield low of 3.071%, a high-yield 10-year corporate could have been bought around a 9.25% yield; that is, 6.20% cheaper than the 10-year Treasury. As 10-year yields rose, this spread narrowed, insulating the investor from the rising Treasury yield environment. In February 2005, with the 10-year yield around 4.25%, the yield on the high-yield bond was around 7.00%, 2.85% cheaper than the 10-year Treasury.
In other words, the yield on the 10-year was higher by 1.18%, while the yield on the junk bond was lower by 2.25%, quite a gain for investors, while the FOMC was raising the fed funds rate. Today, the yield on the 10-year Treasury is at 4.125%, with the yield on high-yield corporates now around 8.25%. The high-yield spread has gone from 285 basis points to around 420 at the end of April, with the bulk of the rise coming after the FOMC rate hike on March 22.
Many well-known fixed-income experts are saying that yields are not rising and in fact could continue to fall. That's not true for investors in corporate bonds or other spread-product securities. Right now, yields are rising, away from the Treasury market, and I expect Treasury yields to resume their rising yield trends once corporate bond spreads stabilize.
In my judgment, the rise in yields will become secular. Here's the strategy I suggest.
I would start by selling corporate bonds and other spread products, beginning with the longest maturity. Keep in mind that the U.S. Treasury will begin to reissue 30-year bonds in February 2006. I'd want to remove the risk that yields move higher well before then.
Next, I'd raise my level of cash. Most likely, I would be selling the bonds at significant gains. If this is done in retirement accounts, there are not likely to be tax consequences, but please check with a qualified tax adviser about your specific situation.
Once my corporate bond positions and other non-Treasuries were sold, I would start selling Treasury holdings, beginning with the longest maturity.
Every six weeks, the FOMC will reward this strategy by raising the federal funds rate, which is highly likely to rise by another 25 basis points to 3.25% on June 30.
For every bond sold above par, I would raise more cash now than when the bond matures, and avoid the credit risks that are evolving in the corporate bond world today. With the cash on hand, I could rebuild a laddered portfolio once yields rose enough to re-establish value and once corporate bond spreads widened to a point where incremental risk made more sense.
Richard Suttmeier is president of Global Market Consultants, Ltd., and chief market strategist for Joseph Stevens & Co., a full service brokerage firm located in Lower Manhattan. At the time of publication, he had no positions in any of the securities mentioned in this column, but holdings can change at any time. Early in his career, Suttmeier became the first U.S. Treasury Bond Trader at Bache. He later began the government bond division at L. F. Rothschild. Suttmeier went on to form Global Market Consultants as an independent third-party research provider, producing reports covering the technicals of the U.S. capital markets. He also has been U.S. Treasury Strategist for Smith Barney and chief financial strategist for William R. Hough. Suttmeier holds a bachelor's degree from the Georgia Institute of Technology and a master's degree from Polytechnic University. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback --
to send him an email.