Investing in bonds

Eric Fry - Fri 06 Oct, 2006

...Bonds are the new "black." Suddenly, these boring financial assets have become sizzling hot portfolio accessories...

  
  
- Bonds are the new "black." Suddenly, these boring financial assets have become sizzling hot portfolio accessories.

- Everybody wants to be seen with bonds, especially long-dated Treasury bonds. But we suspect this investment fashion is about to become "so last season."

- Please allow us to suggest an avant-garde alternative: The bond-free portfolio. We wouldn't abandon fixed-income entirely, however. In the place of 10- and 20-year Treasuries, we'd accessorize a portfolio with baubles like 2- and 3-year Treasuries.

- Long-dated US Treasuries have enjoyed a delightful rally since late June, causing the 10-year yield to fall from 5.25% to 4.56%. Fuelling this rally is the notion that the Fed is finished...and so is housing. In other words, the Federal Reserve has finished raising interest rates for this particular "tightening cycle."

- The next move in short-term US interest rates therefore, will be down, not up. At the same time, the crashing housing market is raising the prospect of recession – a condition that usually causes bond prices to rise, and yields to fall.

- In fact, the Federal Reserve does appear to have finished raising rates in the US...and the crumbling housing market does appear to be dragging the economy into recession. The rallying bond market, therefore, does not lack for ample fundamental support. Even so, the "buy bonds" trade has become so popular and "crowded" that a contrarian-minded investor must consider alternative scenarios – like the scenario that bond prices might not continue rising.

- It's true that the US economy is visibly slowing. Just yesterday, the Commerce Department reported that US factory orders in August (excluding transportation) dropped 0.7% - the biggest drop since February.

- Meanwhile, the Institute for Supply Management (ISM) reported that business activity at service industries in September dropped to its lowest level in more than three years. Manufacturing industries tell the same story. The ISM manufacturing survey for September touched its lowest level since April 2005.
 
- "Excluding the April 2005 reading," observes Asha Bangalore, the insightful economist from Northern Trust, "one has to go back to July 2003 to see a comparable low reading. US indexes tracking production, employment, supplier deliveries, prices, backlogs, exports, and inventories all fell in September.

- "The overall tone of the report is that US factory activity is winding down, perhaps as a result of the housing recession. To wit, a telling quote from the September ISM manufacturing report was: 'Within the past two weeks, [a respondent was] seeing a serious downturn in customer orders related to the housing market downturn.'"

- Corroborating the ISM's downbeat assessment, US residential construction is dropping swiftly. "The July-August average of residential construction outlays shows a 15.4% drop after an 8.5% decline in the second quarter," Bangalore notes. "In other related news from the US housing sector, the Pending Home Sales Index (PHSI) of the National Association of Realtors...is down 14.1% from a year ago."
 
- Bond investors have been feeding on these plentiful signs of economic decay like coyotes on a carcass. But the bull case for bonds includes a couple of caveats.

- First, the US inflation rate many not slow as rapidly as bond bulls hope and believe. Second, the US dollar may not resist the gravitational pull of our excessive government debts and trade deficits. If the inflation rate remains stubbornly high and/or the US dollar resumes its downtrend, the Fed could not easily justify cutting interest rates...even if the economy required it.

- The third risk to bonds is a touchy-feely one: Bonds are too darn popular. The latest CFTC Commitment of Traders report shows that large speculators – a.k.a., the "dumb money" – hold a record-high long position in Treasury-note futures.

- Perhaps that's why one of the smartest bond investors, Bill Gross of Pimco Asset Management, favours short-term Treasuries over their long-term counterparts. For the record, Gross does not dislike long-term Treasuries, he simply likes short-term Treasuries much better.

- "Currently," Gross remarked recently, "PIMCO's best 60/40 bet is a cyclical one that proposes that the Fed is done and ultimately will have to lower rates in order to re-stimulate an asset-based/housing-led economy.

- "With US inflation levelling off at admittedly unacceptable levels and the domestic economy moving towards a 2% real growth rate or less in the next year or so, the Fed at some point in 2007 will be forced to cut short rates.

- "Don't ask us when or by how much yet" Gross continued. "A lot will depend on the evolution of the US housing market and the equally important maturation of the global economy sans US consumer imports and perhaps hyper investment spending in Asia...The US bond bull market, which began almost two years ago, remains in its infancy. But the best way to play it...is the front end of the curve."

- Be the first one on your block to embrace the new fashion.  


Regards,

Eric Fry
for The Daily Reckoning