Title: Investing in the Bond Market: Duration Risk and Market Outlook
Introduction:
Investing in the bond market requires careful consideration of duration risk and market conditions. In this article, we will explore the appeal of owning bonds at different points along the yield curve, considering the current state of the market. We will also examine the arguments for and against adding duration to investment portfolios, considering inflation outlook and interest rate movements. Additionally, we will provide unique insights and perspectives on the topic to enhance readers’ understanding of bond market dynamics.
1. The Appeal of Shorter-Term Bonds:
1.1. Since the Fed has hiked rates, short-term bonds offer the chance to earn significant returns in a short period.
1.2. Yields on one-year Treasuries are above 5%, making them an attractive option for investors seeking current income.
1.3. The short end of the yield curve allows investors to reevaluate their investment strategy once market uncertainties have cleared.
2. The Case for Longer-Term Bonds:
2.1. The improved inflation outlook makes the long end of the yield curve more attractive.
2.2. Locking in a 3.8% yield for 10 years, when pre-pandemic long yields were consistently below 3%, seems like a logical bet.
2.3. Interest rate volatility appears to be easing, supporting the case for extending duration.
2.4. A positive inflation outlook and a Federal Reserve nearing its terminal rate can generate gains from duration.
3. Arguments Against Adding Duration:
3.1. Lower inflation and falling rates are already priced into the market.
3.2. Futures markets expect rate cuts in the coming years, indicating limited potential for further yield decreases.
3.3. Inverted yield curves suggest that falling rates are already priced in.
3.4. The risk of being too low in duration outweighs the risk of being too long.
3.5. The battle against inflation is not entirely won, making it difficult to bet aggressively against the short end of the curve.
4. Market Experts’ Perspectives:
4.1. Scott DiMaggio suggests that investors should focus on smart decisions rather than relying on luck.
4.2. Jim Sarni emphasizes the importance of locking in yields in the middle of the curve to secure consistent income.
4.3. Dec Mullarkey agrees that the current environment is conducive to generating gains through duration.
4.4. Greg Obenshain reminds us that current market conditions may not offer anything exceptional for rates or spreads.
4.5. Ed Al-Hussainy believes that a 2% real yield over a five-year period is a reasonable starting point.
4.6. Thomas Tzitzuuris urges caution due to the uncertainties surrounding inflation and the Federal Reserve’s balance sheet reduction.
Conclusion:
Investing in the bond market requires aligning investment strategies with market conditions and risk preferences. The appeal of short-term bonds lies in the opportunity for quick returns and flexibility. On the other hand, longer-term bonds can offer attractive yields and potential gains, considering the improved inflation outlook and interest rate stabilization. However, caution is advised, as market expectations and priced-in factors may limit future yield decreases. Ultimately, investors should analyze their own investment goals, risk tolerance, and market outlook to make informed decisions regarding duration risk.
Summary:
Investors are presented with opportunities in both short-term and longer-term bonds. Short-term bonds offer substantial returns in a short period with the chance to reassess, while longer-term bonds provide the potential for attractive yields and gains. However, market conditions, inflation outlook, and priced-in factors should be carefully considered. Various experts weigh in on the decision to add duration, emphasizing the importance of smart decisions and income generation. It is crucial for investors to conduct thorough research and align their investment strategies with their goals and risk tolerance in order to make well-informed decisions in the bond market.
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Good morning. Bank of America second quarter report results yesterday, drove home the Message Posted by other big banks last week: Credit quality is still good, consumer is still good, interest rate margins are still good. Shares were up 4% and the entire industry was up. Note, however, that bank stocks are still nowhere near the levels prevailing before the banking micro-crisis in March. Not sure if that makes sense or not. Send me your thoughts: robert.armstrong@ft.com
Longer ties
TO various points over the past couple of years, Unhedged has noticed the appeal of owning bonds at the short end of the curve. Since the Fed had hiked rates, the short end offers the chance to pick up some substantial returns and then reevaluate things in as little as a year or two when the smoke, literal and figurative, has cleared. That argument seems stronger now than ever. Yields on one-year Treasuries are above 5%. Inflation, depending on how you measure it, is about 3 percent. With stocks not looking particularly cheap, why not take your 2% post-inflation yield and see what the stock market has to offer in the summer of 2024?
It seems to me, however, that the improved inflation outlook also increases the attractiveness of the long end of the curve. The 10-year Treasury yield hasn’t moved much since autumn last year, but the inflation picture is clearer and more supportive. Interest rate volatility appears to be easing. If we are on the way back to normal after a period of supply shock inflation, then locking in a 3.8% yield for 10 years – when pre-pandemic long yields were fairly consistently below 3 – seems like a logical bet.
None of this suggests that I know anything the bond market doesn’t. If long-term yields haven’t fallen much while inflation news has improved, there’s a reason for that. But the underlying thought seemed worth exploring. So (being basically a stock guy) I reached out to my favorite fixed income people and asked a simple question: Is duration risk becoming more attractive?
“Yes. I bought 10 US stocks for about 4%, therefore enjoying the returns.” That’s Scott DiMaggio, co-head of fixed income at AllianceBernstein. Presumably he was too busy making money to add much detail. Jim Sarni of Payden & Rygel, made his argument more explicit: “It’s better for investors to be smart than lucky.” That is to say, investors who need income should lock in yields in the middle of the curve – five years or so – without worrying whether they are achieving peak returns. “The risk of being too low is greater than the risk of be too long. If cash flow is important to you, you may no longer see these returns. You need to lock in some.
Dec Mullarkey of SLC Management agrees:
It is certainly approaching an environment where duration can generate gains. The positive tone for both headline and core inflation and a Fed that is about to stabilize near its terminal rate are all constructive for extending the duration. With real rates still near a post-GFC high and inflation cooling, the Fed should have room for sizeable rate cuts next year to support trend-like growth.
However, the argument against adding duration is equally simple: lower inflation and, to some extent, falling rates are already heavily priced into the market. Futures markets expect rate cuts of more than six quarters of a point by January 2025. Five-year inflation break-evens have been parked near 2% for several months now. The inverted yield curve also indicates that falling rates are priced in. Bond yields cannot be expected to fall much when what they should happen happens.
“The curve is already pricing in a decent drop in rates and spreads are normal to slightly tight, so you’re not locking in anything special, either for rates or for the spread,” Greg Obenshain, who manages corporate bonds at Verdad Capital. Regular Unhedged talker Ed Al-Hussainy of Columbia Threadneedle agrees that deflation is widely discounted, but he is still long 5-7 year bonds. A 2% real yield over a five-year period “isn’t a bad place to start,” he says. He is concerned, however, that the battle against inflation is not entirely won, which makes it difficult to bet aggressively against the short end of the curve:
I’m a little nervous here. The chances of the federal funds rate exceeding 5.25-5.5% by the end of the year are about 25%. The Fed would have to revise its inflation forecasts downwards to justify this price. We’re not there yet.
Strategas’ Thomas Tzitzuuris also fears that inflation is not dead yet and adds that bets on higher long-term bond prices have to contend with the fact that the Fed is still shrinking its balance sheet, increasing the offer of long-term bonds. resources. Further easing of the Bank of Japan’s yield curve control program could also siphon money from the US bond market. He’s cautious.
I keep coming back to Sarni’s point, though: try to be smart rather than lucky. We don’t know how close we are to ending inflation and peaking rates, but we know we are close. We don’t know where returns are going, but we do know that it is better to invest with significant positive real returns than the near-zero or sub-zero real returns that have dominated for so long. Adding some duration makes perfect sense.
A good read
A great interview with Joyce Carol Oates: “Suddenly you realize that the human experience is going to be your experience. When this starts happening to you, it’s pretty amazing.
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