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At yesterday’s FOMC meeting the Fed continued to taper its asset purchases at the current pace of $15 billion. With next months bond buying set to be $45 billion, the Fed has just three months before it stops buying bonds altogether.
This begs the question. What happens next? Should they sell the bonds they own, or hold on to them until they mature? And if they are going to sell, which securities should go first? Yet there is another question that is equally important but seldom asked: is it sensible to return central banks’ balance sheets to “normal”? There are good reasons not to.
According to a report in today’s Financial Times. Federal Reserve assets totalled $880bn, at the beginning of 2007. Today, the balance sheet stands at $4.3tn, including $2.4tn of Treasuries and $1.7tn of mortgage-backed securities. The reason for buying these assets was not to reduce the federal funds rate, which had reached zero by late 2008, but to lower the interest rates at which loans are extended to people and businesses, stimulating demand.
There is evidence that Quantitative Easing did indeed lower long-term rates relative to short-term rates, and lowered rates on more-risky compared with less-risky obligations. “A conservative estimate is that a $600bn bond purchase (the size of the Fed’s second round of bond buying) lowered long-term interest rates by about 25 basis points: not enormous, but a worthwhile contribution to the US economic recovery.”
The FT went on to say that the “composition of the assets that the central bank buys matters too.” By buying mortgage-backed securities the Fed effectively narrowed the difference between the interest rate American homeowners pay on their mortgages and the rate at which the U.S. government can borrow.
All this prevented house prices from falling, spurring residential construction in the process. Buying or selling bonds gives the Fed a way of influencing longer-term interest rates in general, and mortgage rates in particular. This lever will remain useful long after short-term rates begin to rise. But it will be out of reach if the central bank returns its balance sheet to its pre-crisis state.
For decades, it has been commonly understood that the central bank’s policy interest rate is the only independent instrument of monetary policy. We now see that there are two: the policy interest rate and asset purchases or sales.
But the central bank cannot sell what it does not own. To keep this additional policy tool available, the Fed and other central banks should hold on to an ample supply of assets. They should not shrink their balance sheets to the pre-crisis size.
Todays Other Top Stories
Betterment: – Betterment portfolios now include municipal bonds. – Betterment have added a municipal bonds asset class to make non-IRA portfolio even more tax efficient.
MarketWatch: – Fitch takes various rating actions on enhanced municipal bonds and TOBs. – Fitch Ratings has taken various conforming rating actions on enhanced municipal bonds and tender option bonds (TOBs) corresponding to actions taken on their associated enhancement providers or underlying bonds.
Cumberland Advisors: – Muni market 2014 halftime show. – The municipal bond market continued to roar ahead in the second quarter with long tax-free yields continuing their decline in April and May before rising slightly in June. Many of the same factors that were at work in the first quarter were again at work in the second quarter.
Yahoo Finance: – Better bets than junk bonds. – With yields on risky corporate debt near record lows, Morgan Stanley financial advisor Jim Moriarity talks about the appeal of high-yield municipal bonds and mezzanine debt.
Bloomberg: – Record run trouncing Treasuries shows tax-free lure: Muni credit. – Tax-free state and local debt has declined 0.5 percent in June, on pace for the first monthly decline of 2014, Bank of America Merrill Lynch data show.
Columbia Management: – What’s the outlook for muni bonds? – Strong YTD performance resulted from falling rates, a dearth of new supply and a resurgent demand by investors seeking attractive taxable-equivalent yields. We believe municipal bonds should continue to perform well in the second half of 2014.
Reuters: – Yields on Puerto Rico bonds jump, prices plummet on Puerto Rico bonds. – After Puerto Rico’s governor signed a law declaring a fiscal emergency, yields on the territory’s junk bonds issued in March soared to their highest levels yet on Wednesday, reaching 9.541 percent in afternoon trading.
Bloomberg: – Pimco’s Gross wagering on low volatility in ‘New Neutral’. – Bill Gross said Pacific Investment Management Co., manager of the world’s biggest bond fund, has been betting that volatility across asset classes will remain very low, as gauges of price swings fall to their lowest levels on record.
Financial Review: – Bond exit fees are not the answer to clients stampeding out. – Now that banks have been stuffed with capital, central bankers fear that the next stampede will happen elsewhere.
Templeton bond manager: – Japan easy money will bolster global liquidity. – Templeton bond fund manager Michael Hasenstab, an influential voice on emerging market debt, said Wednesday that Japan’s easy money policy will bolster global liquidity, but he also warned that debt conditions in the Asian country are worrisome.
Businessweek: – Treasuries advance on Fed’s long-term economic view. – Global investors have piled into US government bonds this year, drawn by the allure of high yields.
MarketRealist: – Were bond prices too high at the 10-year Treasury notes auction? – The prices and consequent yields of marketable Treasury securities (Treasuries that may traded on the secondary market) are decided by competitive bids at public auctions held by the Treasury. Auctions may include first-time issues of securities as well as security reopenings. Reopenings are re-issues of securities offered previously at the same coupon and maturity date, but with a different purchase price.
Northern Trust: – Top 10 reasons the 10-year treasury yield may stay low. – Katie Nixon tells us why U.S. bond yields remain so low, particularly as corporate earnings improve and the U.S. economy seems to be growing.
Income Intelligence: – Singing in the Rain: Investment grade corporate bonds have hit all the right notes. – Investment grade (IG) corporate bonds have had a stellar year. With returns running close to 5% in just the past five months, it’s a natural time for investors to ask the question, is something going to give?
High Yield Bonds
MarketWatch: – Yellen raises concerns about high-yield bonds. – Federal Reserve Chairwoman Janet Yellen raised concerns about overheating in the high-yield bond market Wednesday, even as she reiterated many of the easy-money policies currently in place.
DailyMotion: – Schwab: Time to take out the overpriced junk bonds. – Already low Treasury yields will most likely not fall much further, says Kathy Jones, fixed income strategist at Charles Schwab. Likewise, muni bonds are also fairly valued, primarily due to limited supply as a result of austerity at the local level
B2C: – Do emerging market bonds belong in your portfolio? – Most people have gotten the message they should diversify their portfolio across different asset classes. But when it comes to figuring out what that means for the bond portion of their portfolio, things get a little hazier. I suspect many people aren’t even aware that emerging market bonds are something they should consider. If you aren’t familiar with what your options are, here’s a good overview of the different types of bonds to get you started.
Pensions & Investments: – Asset owners to be more selective with emerging markets — report. – Emerging markets are facing a period of structural reform that will leave asset owners adopting a much more selective approach to investing in those markets, said a report from London-based CREATE-Research sponsored by Principal Global Investors LLC.
Reuters: – Argentina says next bond payment ‘impossible’, default looms. – Argentina threatened to default on its debt on Wednesday when the government called it “impossible” to pay bond service due on June 30, citing a U.S. court decision earlier in the day that increased pressure on the economically ailing country.
Bloomberg TV: – Investors Tempt mother nature in disaster bonds. – Bloomberg’s Julie Hyman and Caroline Chen examine the growing interest in catastrophe bonds as debt investors bet against hurricanes and natural disasters. They speak in “On The Markets” on “In The Loop.”
Chicago Tribune: – Advisers turn to alternative mutual funds on U.S. rate rise fears. – Investment advisers, bracing for the U.S. Federal Reserve to raise interest rates, are seeking alternatives to plain-vanilla bond funds, and some are turning to mutual funds that employ hedge-fund-like tactics, including the ability to bet against securities.
Nanette Abuhoff Jacobson: – To shift or not to shift: Understanding the consequences of hedging market risks. – Investors concerned about rising interest rates or a sell-off in equities have shifted their allocations to offset these risks. But might they be trading one type of risk for another?
Wall St Cheat Sheet: – 5 funds to consider as prices climb. – Preparing for inflation is more than simply buying “real assets.” Many investors assume that in an inflationary environment it makes sense to indiscriminately own stocks, commodities, and real estate. But there is a problem with this approach.
Charles Patton: – Avoid fixed income risk in your retirement portfolio. – The general rule of thumb for asset allocation is to increase your holdings in bonds as you get older. This is because bonds generally have had less risk and provide a more stable income than stocks. For these reasons, bonds make increasingly more sense as you move out of your wage earning years and into retirement. This advice worked well for the previous generation. Unfortunately this trend can not continue.
Regarded Solutions: – Retirement Strategy: Chasing yield is actually looking for disaster. – Current fixed income interest rates are so low that those seeking income for retirement have gone to extreme measures. A dividend opportunity stock is fine for a risk allocation, not for a total portfolio.
Fox Business: – Best opportunities for investors outside the U.S.? – LPL Financial Fixed Income Investment Strategist Anthony Valeri, Cambria Investment Management CIO Mebane Faber and AverageJoeOptions.com founder Todd Horwitz on where the opportunities are for investors.
ETF Trends: – A Wonderful REIT ETF. – Relief in the form of this year’s 12% decline in 10-year Treasury has lifted real estate investment trusts (REITs) and the corresponding exchange traded funds.
Bloomberg: – My go-anywhere bond fund shines if you ignore 2014 gains. – However you want to read Federal Reserve Chair Janet Yellen’s comments yesterday, managers of go-anywhere debt funds have the solution to your concerns.
In putting together the latest #Municipal Default Trends we noted an overall increase in material event notices. Likely linked to SEC’s MCDC
— Muni Market Advisors (@Muni_Mkt_Advis) June 19, 2014
5s 30s 176ish going into auction.
— Ed Bradford (@Fullcarry) June 19, 2014
— Mary Childs (@mdc) June 19, 2014