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Tags: Waning | Inflation | redraws | Bond

Waning Inflation View Redraws Bond Market Bets

Tuesday, 03 August 2010 02:22 PM EDT

As the U.S. economy has lost some momentum, markets have swung from fretting about inflation to bracing for a brush with deflation, triggering some major bond market shifts.

Rather than fearing they need to buy protection against inflation, investors earning near zero in cash are prioritizing the hunt for yield.

With inflation running at a low of about 1 percent, some fund managers have upped their purchases of longer maturity corporate bonds in preference to safe-haven government bonds. Longer-dated bonds are the biggest gainers when inflation is tame.

Those still nervous about stocks but unimpressed by very low Treasury yields have sought high-yield corporate bonds that tend to be less volatile than equities.

"When you look at the 8 or 9 percent you can earn, you really have to believe economic growth will deteriorate rapidly to make that (investment) a problem," said Dan Peirce, a portfolio manager responsible for global asset allocation at State Street Global Advisors.

Most economists do not expect severe deflation or a depression, which could cause a surge in corporate defaults and losses for junk bond holders.

Instead, the consensus view is for muted inflation. Economists' latest forecast for core U.S. consumer prices is a 0.8 percent rise in the third and fourth quarters and for a 1.1 percent reading in the first quarter 2011.

A deceleration of the economy's growth pace has pushed the benchmark 10-year Treasury note's yield below 3 percent from as high as 4 percent in April as investors have flocked to this traditional safer-haven. Yet that drop in yield has dimmed government bonds' appeal, some say.

"Treasury bonds look pretty expensive" after their rally year-to-date, said Peirce. "We have been more than happy just to own corporate bonds instead and that has worked out fine."

Although corporate bond yields are at historic lows in some cases, they still offer nearly 200 basis points more than Treasuries, an incentive for those who expect the economy to grow feebly but to escape a recession that would spawn high numbers of corporate defaults.

"We have been seeing some good buying in investment-grade and high-yield securities because of this scenario," said Kevin Flanagan, chief fixed-income strategist with Morgan Stanley Smith Barney in Purchase, N.Y.

The buying has given a stellar corporate bond market rally a second wind. The rebound started in the depths of the credit crisis in December 2008, when U.S. investment-grade yield spreads hit record wides above 650 basis points.

This rally stalled in April as concerns about the global impact of Europe's sovereign debt crisis and the possibility of a "double-dip" U.S. recession began to stalk markets. But in recent weeks, fears about both factors have abated somewhat, allowing corporate bond yields to resume a tightening trend.

U.S. investment grade corporate bonds have returned 8.3 percent year-to-date and junk bonds have returned 8.4 percent, according to Bank of America Merrill Lynch data.

With no inflation on the near horizon, Treasury Inflation Protected Securities have fallen out of favor as a wager on the shorter-term economy and interest rate outlook.

William Bellamy, director of fixed income with Thompson, Siegel & Walmsley in Richmond, Va., sold his holdings of inflation-indexed securities during the global financial crisis in 2008. He has not bought any since, expecting downward price pressures in the economy to persist.

"I have been a deflation guy for two years and will be until I see the signposts change in the economy," he said.

Yet some fund managers have hung onto longer maturity inflation-indexed bonds and other fixed-income securities that would do well once rates start to rise.

Although TIPS are not widely sought now, says Peirce, they also haven't generated big price losses for holders and are a useful bet on longer-term inflation expectations.

Some fund managers are buying step-up bonds, whose coupons automatically reset higher at regular intervals, as a bet that the trillions of dollars of debt the government issued during the financial crisis may eventually ignite inflation.

For example, in June, William Larkin, portfolio manager with Cabot Money Management in Salem, Mass., bought a Morgan Stanley step-up bond due in July 2025.

The 5 percent coupon on this bond will rise to 6 percent in July 2013 and 8 percent in July 2016. That's a good hedge against inflation if inflation and interest rates start to rise, provided the issuer has not called or redeemed the security by then.

© 2024 Thomson/Reuters. All rights reserved.

As the U.S. economy has lost some momentum, markets have swung from fretting about inflation to bracing for a brush with deflation, triggering some major bond market shifts. Rather than fearing they need to buy protection against inflation, investors earning near zero in...
Tuesday, 03 August 2010 02:22 PM
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