Tuesday, July 1, 2014

Summer 2014 Part 2

Bond investors have enjoyed the first part of a rollercoaster ride over the past five or six years. Anyone that has been holding onto a portfolio of bonds and other debt instruments that were issued “pre-crisis” have seen their portfolio benefit from interest rates around the world racing to the bottom.

As all good things must come to an end, so must the bull market for debt. Monetary cycles across the globe are normalizing, with the exception of the mainstays of the developed economies. But they too, as growth begets growth, will begin to normalize as well. Leading the way is the Federal Reserve with its hand firmly on the short end of the yield curve holding short term rates low. It is playing the role of buyer of last resort in the long end of the curve as well, to help stimulate the housing market by restraining mortgage and other long term borrowing rates. The Fed has begun consistently tapering its long maturity debt buying and will soon give up its active influence over long term interest rates. At which point, I think it’s safe to assume long term interest rates will start drifting higher.

The next step in the normalization process, would be to raise short term rates. If the Fed lets the long end of the yield curve drift higher and continue to hold short term rates this low, the market might start pricing in higher inflation expectations. If this happens, and the Fed does actually need this to happen, they can raise short term rates to stem price inflation.

As this plays out, bond portfolios will see price depreciation as the securities are re-priced to match the rising interest rates or inflation expectation.

Best course of action for a bond investor sitting on a portfolio of securities that have appreciated; take profits. Starting with the longest maturity securities and work your way backwards. There really isn’t much in the way of hedging the interest rate risk that the average debt portfolio faces from this point going into the next five years. But, since the Fed should not be under any undue pressure to raise short term interest rates until the summer of 2016, the short end of the yield curve (3 – 6 month maturities) would be a safe place to shelter the fallout from the monetary normalization cycle that is in a nascent stage in the US, and a growing list of economies around the world.

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