Schwab Bond Sector Views: Repositioning During the Recovery

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
September 2, 2009

Key points

In the current environment, mortgage-backed securities and US Treasuries appear to have limited upside.
We see more opportunity in high-grade corporate bonds and municipal bonds.
Intermediate-term maturities look to be the best bet in the yield curve today, for a balance of yield and interest-rate protection.

As the economy has stabilized and the credit crisis subsided, bond markets have settled significantly. More credit-sensitive sectors—including corporate and municipal bonds—have rebounded in price and stabilized.

The steady march of new issues of Treasury securities to help support government stimulus are a concern, however, as is an expanding budget deficit. Demand has remained strong for Treasuries so far, despite the large issuance.

These views expressed below reflect Schwab's outlook on sectors of the bond market—Treasuries, mortgage-backed, investment-grade corporate and municipals—as well as our thoughts on interest rates and yields.

This outlook is intended for bond investors with new money to invest, or those adjusting their portfolio to take advantage of relative value today, or align risks with their current investment goals.

Treasuries: TIPS for inflation protection
During the past two months, yields have stabilized at around 1% for two-year Treasury notes and 3.5% for 10-year Treasury bonds. The daily moves in interest rates based on daily economic news signals to us that the market is returning to its more typical pattern. The upside to adding to current Treasury investments, however, appears limited, unless your primary objective is stability to help offset volatility in your stock investments.

Treasury inflation-protected securities (TIPS), on the other hand, may still offer good value. Currently, TIPS are priced to anticipate 2% inflation during the next 10 years. So if you're concerned about inflation being higher than those levels, as many are given the massive liquidity injected into the system during the past year, TIPS will offer some protection. Their yields will rise as inflation rises, and should perform better than normal Treasuries if inflation increases more than expected.

Some common investor comments and concerns:

Treasuries provide safety. This is true, within reason, especially if economic growth stagnates and we experience a double-dip recession. However, there is risk in rising interest rates, especially for longer-term bonds─any bonds you hold at yields lower than those of new bonds being issued will decline in value, unless you hold to maturity. Use Treasuries as a part of your portfolio to stabilize against fluctuations in stocks, but look to build out income with investments in other sectors if income is your objective.
The income from TIPS is too low. For those seeking income from current yield, TIPS do pay lower yields than regular Treasuries—the price paid for the extra inflation protection. The increased payout for any rise in inflation is paid out partially in increased coupon interest payments, and the rest when the bonds mature. For more, see the article in the sidebar at right.
Deflation is a bigger concern than inflation. Deflation may indeed be a bigger issue than inflation today, given the amount of wealth that has evaporated throughout the world economy during the past year, as well as tenuous signs of economic growth ahead. If there is deflation, or if inflation simply stays in line with the 2% currently expected, TIPS won't fare as well.

Government mortgage-backed securities: Limited upside due to yields just over Treasuries
Mortgage-backed securities (MBS) are currently yielding less than 0.4 percentage points above Treasuries, down from last year’s spread of greater than 2 percentage points. With spreads this narrow, there's virtually no upside in price appreciation. But MBS may still make sense for investors seeking marginally higher income.

Although mortgage markets continue to struggle, Ginnie Mae MBS have always been backed by the US government, so if the underlying mortgages don't pay, the government will. Freddie Mac and Fannie Mae bonds now enjoy government support, as well.

Given this government support, credit quality of the underlying mortgages doesn't matter to the end investor. This support is one of the reasons mortgage rates have stayed low, along with yields of government mortgage-backed securities.

Common questions:

Will Fannie and Freddie continue to enjoy government support? Or will they be rolled back out as private companies again at some point as mortgage markets recover? This is a big unknown for the long term, but for now we believe the government support will continue, because to remove it could jeopardize the recovery of US housing markets and the economy.

Investment-grade corporate bonds: Benefits in higher yields
The difference in yield between corporate bonds and Treasuries has fallen back to pre-recession levels. Further gains in price will depend on sustained economic growth. But the higher yields compared to Treasuries make corporate bonds attractive, either in a well-diversified individual bond portfolio or an intermediate-term bond fund or corporate bond exchange-traded fund (ETF).

Common concerns:

Credit markets have more room to unwind. Though bond and credit markets have healed considerably, few would argue that the unwinding of credit excesses of the past 10 years has resolved itself completely. The ability of corporations to pay their bond obligations depends on stable or improved economic conditions as well. Bonds don't need major growth, like stocks, but they do need stable credit markets and a healthy economy.
We could see a double-dip recession, sending corporate profits down again. A double-dip could hit weaker corporate bond issuers hard, especially those at the lower levels of investment-grade. Defaults (and downgrades) on corporate bonds tend to lag in recessions. But downgrades matter as well. So pick stronger issuers, and diversify by sector and individual issuer.

Municipal bonds: Benefits still significant for higher-tax investors
The difference between yields for the highest-quality muni bond issuers and Treasuries has moved back toward its historical relationship, with the munis yielding between 60% and 80% of equivalent Treasuries of the same maturity. Of course, muni bonds are exempt from federal tax, so their yields before accounting for the tax benefit are lower.

For higher-tax investors using taxable accounts, munis still make sense. State and local budget deficits, along with weak municipal revenues, are certainly a concern, but protections for highly rated muni bonds are strong. And with tax rates likely to increase to support soaring federal deficits, demand for munis should remain strong.

Common concerns:

Many state and local governments have serious budget problems. This is undeniably true, but historical muni default rates have been extremely low. The weakest municipalities, however, may struggle. Stay diversified, and try to select issuers in areas or in sectors least exposed to weakened housing markets or revenue bonds in more stable "essential-service" businesses (like water or sewer services).
Historical defaults understate the risks ahead. Yes, historical default rates have been low, but will they increase given the severe budget problems in states and local governments nationwide? We don't expect defaults to rise significantly. But credit quality is important, to lessen the impact of drops in price in the event of rating downgrades. Stick with higher-rated issuers, A+/A3 or higher, for the bulk of your portfolio, or a good state or national muni fund.

Note on municipal notes: Short-term cash-flow borrowings, or notes, are the equivalent of a pay-day loan for governments. Even the most solvent governments use them, due to the "lumpiness" of municipal tax collections and smoothness of annual costs. These notes are a critical source of cash financing. The state of California plans to sell more than $10 billion in revenue anticipation notes (RANs) in September, for example, to meet cash-flow needs before the bulk of the state’s tax revenues start arriving next spring.

The security protections for municipal notes are generally weaker than for long-term general obligation (GO) bonds, and don't always benefit from a pledge to raise taxes if necessary. They don't carry FDIC or other government guarantees, as do certificates of deposit or Treasuries. Yields may be higher for investors not seeking safety in federal support,

Maturity and duration
Intermediate-term maturities in the five- to 10-year range offer a balance between yield and interest rate risk for any fixed income security. Rates remain near record lows, and an increase in rates would drive down prices on long-term bonds faster than prices on shorter-term bonds.

If you'd purchased a 30-year Treasury bond, for example, at the recent bottom for yields last December, the value of that investment would be down nearly 25% today. A 10-year note, in contrast, would be down less than 10%. The risk of rising interest rates affects non-government bonds, as well.

Unless you believe rates will remain at current levels, or have fixed future costs, know exactly when you'd like you're principal returned, won't worry about the opportunities in other bonds if rates rise, and know you'll hold to maturity, stick to maturities of less than 10 years.

Counter-arguments:

A steep yield-curve benefits longer maturities. The yield curve—meaning the difference in rates between short and longer-term bonds—is close to the steepest it's ever been. This means that short-term yields are extremely low (driven largely by the very low federal funds rate set by the Federal Open Market Committee) compared to longer-term bonds. But long-term rates are far from high, compared to historical levels, and have been kept from going higher by Federal Reserve purchases of longer-term Treasuries and other bonds.
I need income now. Unless you know you want to lock in the slightly higher rates now, intermediate-term maturities will fall in price if rates rise. You also won't be well positioned to take advantage of higher rates (and income) later. Resist the temptation to lock in these long-term rates, again, unless you know you'll hold to maturity and won't be too concerned about opportunity costs, inflation or a drop in price.
Rates may stay low longer than we think. It's certainly possible. Japan has had greater than twice our federal deficit and percent of government debt compared to gross domestic product (GDP), for nearly 20 years; and interest rates there have hovered at levels below our own extremely low rates today. Rising rates are not a foregone conclusion, especially if the economy fails to move from recovery to growth.

How to invest?
Regardless of your market view, we believe that a well-selected intermediate-term bond fund (or funds), or an indexed exchange-traded fund seeking to mirror the US bond market is a good starting point for a well-diversified fixed income allocation. Then, consider these tactical views when considering additional investments, or seeking to explore other sectors or weightings as part of your fixed income portfolio.

As a benchmark, the investment-grade US bond market looks like this: 40% Treasuries and government bonds, 40% government mortgage-backed securities and 20% investment-grade corporate bonds, with an average maturity between five and 10 years.

For ideas, refer to the Schwab Mutual Fund Select List™ or the ETF Screener on Schwab.com. For additional advice or help with individual bonds, see Schwab BondSource or speak with a fixed income specialist at 800-626-4600.

Important Disclosures

Investors in mutual funds and exchange-traded funds (ETFs) should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

ETFs are subject to risks similar to those of stocks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the US government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the US government and may be adjusted for inflation to become the greater of either the original face amount at issuance or that face amount plus an adjustment for inflation.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

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