Buy low and sell high. It applies to bonds as well as stocks. Now, after a furious rally, it’s time to take profits on long-term bonds that have soared in price as their yields have plunged.
So say several astute observers of the fixed-income markets, some of whom also suggest swapping the bonds for floating-rate securities that have lagged this year’s bond rally.
With the benchmark 10-year Treasury yield down to around 2.15% from a peak of about 3.25% last fall, it’s time to prune bond portfolios and take advantage of “the present the Fed has given us,” writes the inimitable Mark Grant, chief global strategist for fixed income at B. Riley FBR in his Out of the Box missive Wednesday.
What’s significant is that previously he was vociferously—and correctly—calling for long bond yields to fall and prices to rise, even when the consensus call was the opposite.
Now that market expectations have taken a 180-degree turn—from the Federal Reserve raising its short-term policy interest-rate targets to an equal certitude the central bank will be cutting them—the investment-grade bond market has enjoyed a terrific rally this year.
For those who participate in the market via exchange-traded funds, the iShares 20+ Year Treasury Bond ETF (TLT), has posted a total return of 9.13% since the beginning of 2019, according to Yahoo Finance. The more diversified and less volatile iShares Core U.S. Aggregate Bond ETF (AGG) has returned 4.98% year to date.
To squeeze out more gains would require a fall in yields from already historically low levels. If yields stay where they are, an investor earns just the paltry coupon interest of a bit more than 2%. Investors in a 10-year Treasury note at current prices and yields, a mere reversal to just 2.40%—where it traded in early May—would essentially face a return equivalent to cash in the mattress, or bupkis, to use a technical term. Except you’d have to pay taxes on the interest coupon, so you’d be worse off.
Grant suggests some basic gardening techniques for bond portfolio management, pruning some appreciated issues to take a profit. Those should be replaced with higher-yielding or better-quality credits, he says. Obviously, that recommendation depends on individual circumstances, including taxes and transaction costs.
Other keen-eyed observers point to macro trends that can be exploited. For instance, Stan Shipley, strategist for Evercore ISI—which is headed by the redoubtable Ed Hyman—spies an interesting trend in the asset-backed securities market, where loans for automobiles, student debt, credit cards, and home-equity loans are packaged and traded.
Yields on fixed-rate ABS have plunged 70 basis points (or 0.7 percentage point) since last November, Shipley writes in a client note Wednesday. Now fixed-rate ABS trade at yields 40 basis points below floating-rate ABS, a reversal from last October, when fixed-rate ABS traded some 60 basis points higher than floaters.
Why the reversal? Fears of a recession spurred rate-cut expectations, causing fixed-rate ABS to rally in price and fall in yield. The shift is a classic recession signal, as investors seek to lock in fixed rates before they fall further, Shipley adds. This also happened in 1998 and 2012, but without presaging a recession, he points out.
“The investment implications are clear. BUY FLOATING, SELL FIXED,” he writes in underlined capital letters for emphasis. That’s if you concur with Evercore ISI’s call that there is no near-term recession on the horizon. As recession fears abate, he sees the relationship reversing, with fixed rates rising back above floating-rate ABS.
Coincidentally, Bespoke Investment Group comes to the same conclusion in tracking the relevant ETFs. From mid-2016 to late 2018, the iShares Floating Rate Bond ETF (FLOT) outperformed the broad bond-market iShares Core U.S. Aggregate Bond ETF by six percentage points. Since expectations for short-term rates have flipped to the downside, the latter ETF has outperformed the former by six percentage points.
That switch also has been apparent in the preferred-stock market, where floating-rate preferreds have lagged fixed-rate preferred shares. That suggests “a clear opportunity in the fixed-income markets,” BIG writes in its Fixed Income Weekly research note. That is, shift from low-coupon, long-term bonds in favor of short-term, high-coupon and floating-rate securities.
Closed-end funds that emphasize the sort of securities with characteristics that Evercore ISI and BIG like were recommended late last year in this column, but they now trade at significantly higher valuations. Still, the recommendations bear repeating.
Even though they no longer trade at double-digit discounts to their net-asset value, the preferred-stock closed-end funds highlighted then still provide yields over 7% and were quoted just under NAV. These include the Cohen & Steers Limited Duration Preferred & Income fund (LDP) and the Nuveen Preferred & Income Securities fund (JPS).
Last year, smart observers were saying the opportunity was to lock in long-term yields that were more likely to decline than continue rising. Now they’re saying yields aren’t likely to fall further. Following their calls means going against the conventional wisdom, which proved correct last year.
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