What's the Scenario for Bonds in 2012?

 | Dec 29, 2011 | 11:30 AM EST  | Comments
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This column originally appeared on RealMoney Pro.

Every year I am asked a year-end forecast piece, and every year I oblige but perhaps not exactly in the way expected. See, I've never been a big fan of investing based on forecasts. It tends to lock in your mind on a particular outcome, which could have you investing all your assets based on a single strategy, and I've never thought this was a terribly smart way to invest.

Instead, my group tends to think about possibilities and probabilities rather than forecasts. Start with the scenario we think is most likely but then think of at least one or two other scenarios that are also reasonably possible. We try to think beyond simple optimistic/pessimistic scenarios, thinking through some of the details as to how these scenarios might play out.

We can then take this a number of ways. Sometimes you'll see certain market moves that are likely in all your scenarios. For example, last spring, I suggested taking yield-curve-flattener positions (i.e., where the gap between short-term yields and long-term yields narrows). That's because we figured that if growth accelerated, the Fed would start hiking rates and short-term yields would rise more than long-term yields. But if growth declined, short-term rates were already about as low as they could get, logically long-term rates would fall more than short-term rates. The trade worked, even though at the time the former was what I considered more likely.

Thinking about multiple scenarios at once allowed me to avoid a disastrous duration-based positioning for Fed hikes and instead focus on the curve-flattener.

Of course, you can't always find these kinds of win-win strategies, but you can often find specific bonds that will do well in one scenario while still holding up in another scenario. You can also be thinking about your total portfolio. We want to have a portfolio that can outperform in our most probable scenario yet at least perform in line in our less likely scenarios.

So, once again, for my 2012 forecasting column, I'm not going to give you a whole lot of specific numbers. I think it is more informative for the reader to hear how we really invest as opposed to read some meaningless forecast. We'll go through the major bond market sectors and see what the best risk/reward strategies might be for 2012 given the range of expected outcomes we present.

Markets in 2012 will likely be dominated by how Europe deals with its sovereign crisis. I offered my thoughts on how we're dealing with the extreme uncertainty there in this piece from last week.

The Fed and the Economy

While I think the employment and overall economic trend is improving, growth is very unlikely to break out to the upside in 2012. I see general uncertainty being too high for businesses to start aggressively investing and/or consumers aggressively spending. Between Europe and the U.S. general election (among other items), there isn't an obvious scenario that diminishes this uncertainty, so I think that the risks to my mildly optimistic growth forecasts are to the downside.

The Fed will likely respond with additional monetary accommodation, probably focused on buying mortgage bonds. They will also likely to push out further their current pledge to keep rates low through 2013. I suspect this won't come in the form of a specific date pledge, rather more color around what it will take to start removing accommodation. The market will see that it will take a lot before the Fed starts hiking and therefore begin pricing the market as though short-term rates will remain near zero for most of 2014 as well.

Most of the above is priced into current bond prices. So in thinking about our Fed forecast, it is less about the possibility that they don't do any of the above and more that they do a little less than the market currently has priced in.

Interest Rates

Almost everything about the world economy is putting downward pressure on U.S. Treasury yields. Central bank policy is accommodative and likely to get more so. Growth is anemic and seems to be slowing, particularly in Europe. Inflation is mild and doesn't appear to be accelerating. While government bond supply is heavy, non-government bond supply is very weak. More importantly, the universe of government bond markets perceived as "safe" has diminished markedly in the last six months.

The only negative thing you can say about the Treasury market is valuation. Yields are so low that they probably have all of the above positives already priced in. Yet I do not believe that valuation alone is enough to warrant a negative view on Treasury bonds in 2012.

Rates are likely to remain around where they are now, especially as long as Europe remains so uncertain. The upside is limited, of course, and therefore, I'd rather hold duration in other sectors. But rising interest rates aren't going to keep me away from owning longer corporate, muni or mortgage-backed securities positions. Tactically, I'm more likely to take long positions on Treasuries selloffs than consider short positions after rallies. Watch the spread between U.S. Treasuries and German Bunds. I expect for most of 2012, Treasuries will trade with a slightly lower yield than Bunds. Currently Treasuries are 12bps higher than Bunds.

Given my view on the Fed (above), the one area of the Treasury market that is somewhat vulnerable is the 30-year segment. Thirty-year bonds will price much more based on the long-term view of inflation and the credibility of the Fed. While I do not see inflation accelerating in 2012 much, it is possible that the market starts to view inflation as rising in the longer term due to an overly accommodative Fed. I'm playing this mostly by just avoiding the 30-year sector entirely.

Corporate Bonds

This is where investing in 2012 is going to get real challenging. With interest rates likely to remain low, look for investors to reach further and further for yield in 2012. This should generally benefit corporate bonds, but the significant economic uncertainty requires you to pick your spots. Unlike in the middle of the 2008 crisis, the easy-to-own company bonds (good balance sheet, steady business) are very expensive. Everything else is cheap -- but for a reason.

Banks are cheap. The pre-crisis average spread between financial corporate bonds and non-financials was 28 basis points, according to Barclays; the spread is now 151 basis points. Yet financials clearly have the most downside given an adverse outcome in Europe. And since I don't expect the European clouds will disappear overnight, I expect financials will remain extremely volatile in the interim.

High-yield is also cheap, and at times it will be worth buying. Trouble is that companies are junk for a reason. Most high-yield companies have either significant leverage -- and therefore are exposed to the need to roll over their debts regularly -- or are in volatile businesses. Given the high degree of economic uncertainty, you can't afford to blindly buy leveraged companies or highly cyclical businesses; both probably have significant downside. High-yield has enough volatility to make it worth owning tactically from time to time, but as a buy-and-hold, it isn't an easy buy.

Instead, we are looking at companies with strong balance sheets that operate in cyclical industries. Bonds in cyclical business lines are relatively cheap right now. The three widest non-financial sectors -- real estate (up 308 basis points vs. Treasuries), materials (up 258 basis points vs. Treasuries), energy (up 240 basis points vs. Treasuries) -- are all cyclical. I prefer to find companies with better balance sheets and stronger management in these sectors than try to find weaker names in better sectors. This gives me the confidence to hold the bonds through a weak market, knowing that a well-run company can manage its way through the weakness. The time to own more heavily leveraged companies is in a rising-tide-lifts-all-boats market. This isn't it.

Mortgage Bonds

Mortgage borrowing rates are likely to fall further. Right now based on how the mortgage bond market is trading, 30-year non-Jumbo borrowing rates should be around 3.60% with no points. According to Freddie Mac's survey, rates are actually 3.91% with 0.7 points on average. Using a historic spread to the swaps market (typically used by banks to hedge their mortgage portfolio), it suggests that 3.00% is within the realm of possibility.

Even if rates don't fall much from here, large swaths of the mortgage market are already refinanceable. Given how high mortgage-backed security dollar prices are, that makes these bonds quite dangerous. Don't let the relatively high yields on mortgage bonds fool you; this is a market within which you really need to know what you are doing.

We are buying a fair amount of very low coupon shorter-term mortgage-backed securities. They have lower nominal yields than their 30-year counterparts, but if you actually do the refinancing math, you'll find these kinds of mortgages take significantly larger changes in interest rates to make a refi economical. If you buy bonds full of very low-rate mortgages already, you can be relatively sure you'll keep your income stream.

Municipals

Muni supply is likely to be very light in 2012, while valuations remain very attractive. The muni/Treasury ratio (which is simply muni yields divided by Treasury yields, usually in the 10-year sector) remains above 100% vs. a more typical 80 to 85%. Although retail investors really don't like yields in general, they will be persistent buyers in 2012, as volatility in stocks supports bids for bonds.

Lower-quality munis are one of the easiest trades here. Similar to my idea about corporate bonds above, if you can buy a relatively strong hospital or airport bond here, do it. The yields on those kinds of bonds are actually cheaper than corporate bonds in most cases, even before you consider the tax-exemption. Just pick your spots. In munis, you really have to know what you are buying, as liquidity can be very poor and disclosures are lacking. But if you can find something you are comfortable with, I think these kinds of bonds benefit from the coming yield grab as well.

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