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Investing in the Surging Bond Market

Written By Brian Hicks

Posted August 13, 2013

It seems widespread concerns over an imminent tapering-off of the U.S. Federal Reserve’s asset-buying stimulus program are abating—and with that, corporate bonds are bouncing back up.

bernankeBloomberg notes that mutual funds and ETFs focusing on dollar-denominated, high-grade notes racked up $639 million in deposits for the week ending August 7. That’s the highest in over two months.

From Bloomberg:

“The Fed did a good job in convincing the market that tapering isn’t necessarily tightening,” Ashish Shah, the head of global credit at AllianceBernstein Holding LP, which manages $435 billion in assets, said in a telephone interview. “The stability we’re seeing in Treasuries is helping people come back into the market to find pretty attractive yields.”

Over the past ten weeks, some $8.3 billion leaked out of bond funds as investors withdrew en masse. However, high-yield funds saw $566 million in cash flowing in for the period ending August 7 (after they lost $582 million to outflows just the previous week).

It appears the market is calming down somewhat. The fears of tapering-off are gradually morphing into expectations of tapering-off; investors are taking appropriate action by moving into higher-yield assets.

Certain indexes rose—like the Markit CDX North American Investment Grade Index (a credit-default swaps benchmark), which was up 0.2 basis points—but others fell—like the London Markit iTraxx Europe Index (another credit-default swaps index), which was down 0.2. Bear in mind that these indexes typically fall in response to rising consumer confidence and rise as confidence craters.

One reason bond-buyer confidence is moving up is, of course, higher-than-expected corporate profits across the board. Most companies in the Standard and Poor’s 500 Index showcased Q2 earnings that exceeded analyst estimates by an average of 2.8 percent. And recently, Moody’s reduced its expectations for global default rates from 3.2 percent to just 3.

Meanwhile, AIG (NYSE: AIG) of U.S. bailout infamy recently issued its first dividend, stating that profits were up 17 percent over Q2. Even Morgan Stanley’s (NYSE: MS) Q2 earnings were well above estimates. The company has said it will buy back $500 million in shares.

Since 2008, relative yields on notes have dropped by 4.51 percentage points. However, that’s still 32 basis points higher than the average during the ten years ending in 2006.

According to Pat McCluskey of Wells Fargo Advisors, you as an investor would do well by focusing on shorter-maturity bonds from highly credit-worthy borrowers. The message is obvious: aversion to risk is a good thing. Rising interest rates and high default rates must both be reckoned with.

Key Indicators

Next week, the Fed’s FOMC minutes may reveal much. Current estimates, according to FXStreet, peg the tapering-off announcement at the Fed’s September meeting. Of course, that is by no means certain, and it just means things will continue to wallow in some measure of uncertainty for a few months to come.

David Kotok of Cumberland Advisors provides some analyses to Business Insider. The key facts are that, firstly, risk is increasing as far as the stock market is concerned. Mostly, this is due to the flurry of economic data that’s about to be unleashed, but the Fed’s tapering-off is also hanging over everyone’s heads, and that’s playing a key role too.

To top it all off, the Fed is due for some major personnel changes. There’s an ongoing debate as to whether Janet Yellen or Lawrence Summers will succeed Ben Bernanke at the Fed, but other upcoming personnel changes all point toward a radically “new” Fed in very short order.

Meanwhile, the profit share of U.S. GDP is on a high while labor share is at one of its lowest levels. In other words, productivity is high, meaning resultant earnings should hold strong. But it’s more likely that the GDP profit share is peaking and is about to enter a sustained decline. That’s to say, earnings growth rates for American companies are likely to slow down a bit. Overall, precisely selected bonds and ETFs appear to be the best options.


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