We first addressed this topic on this blog in early June, 2012, so 15 months later, we thought we’d update our thoughts for clients, and readers, and let you know where we stand currently, in what is a treacherous interest-rate environment, but maybe not for the reasons that you think.
First, we typically run conventional fixed-income allocation for clients, with fairly standard asset allocations amongst the various fixed-income asset classes, and then make tactical adjustments for capital market conditions and valuation differences amongst the asset classes. In plain English, we usually run standard portfolios, unless conditions dictate otherwise, within the various groups.
June, 2012 vs today’s client weighting:
Cash: Was 5% – 10%, versus a 10% to 40% weighting today, with the difference attributable to whether the client writes checks on the account, and whether the account is taxable or tax deferred (i.e. an IRA, SEP or pension). Taxable accounts now have an allocation to municipal closed-end bond funds like Nuveen’s Municipal Value closed-end ETF (NUV) Blackrock’s Municipal Enhanced closed-end fund ETF (MEN). Much has been written about the attraction of the closed-end fund discounts to their historical average (currently trading at a discount to 3 – 5 year range) including our post here on this blog.
Investment grade bond funds: 10% – 15% weighting versus 0% today. Our biggest fear was the interest rate risk for high-grade bond funds, so we ended up selling all our high-grade bond funds from Metropolitan West, Neuberger, and PIMCO;
Unconstrained bond funds: from heavy overweight between 30% – 50% of accounts to 0% today. Our opinion is that with US, Japan, Germany and other sovereign bond markets rising, unconstrained bond funds would also feel pressure in terms of price. We sold our PIMCO, Goldman, and remaining unconstrained bond funds, and converted the funds to cash;
High yield Bond funds: 10% – 15% versus the HYG ETF for a trade today. Nominal corporate credit spreads have improved from 4.5% to 6.5% in the last year as the 10-year Treasury has risen, and we expect defaults to continue to be low as the US economy improves. Still high yield ETF’s have a duration, and thus even with good credit spreads, the ETF’s will decline in value. We are long some HYG currently for a trade.
TBF – Unlevered Inverse Treasury ETF is now our single largest position in client balanced and 100% fixed-income accounts. We have chosen the unlevered TBF rather than the levered TBT since TBF allows us to be more patient. Given that the ProShare Inverse Treasury complex has a cost associated with the Inverse attribute, you cannot simply buy-and-hold these ETF’s. The TBT is a trading vehicle given its double-leverage (no positions) while the TBF can be held, just NOT for long periods of time as NAV will decay and erode thanks to the cost of leverage.
Mutual Funds: 60% versus just 3% – 5% today. The only open ended fund we remain long today is the BlackRock Floating Rate B0nd Fund. Given the unlimited duration of open-ended bond funds we have mved to closed-end funds and ETF’s more as trading vehicles than buy-and-hold vehicles.
A decent real-time example of how the “cost of leverage” works in Inverse Treasury ETf’s is that in late August, around August 22nd to be exact, the 10-year Treasury hit a near-term high of 2.92% while the TBF (Proshare Inverse Treasury ETF) hit a high of $33.63. Today, the 10-year Treasury is trading at a multi-year high of 2.95%, or above the August 22nd high, but the TBF is trading below the old high at $33.10.
The Inverse Treasury trade is as much about volatility and timing as it is about direction, much like the options market, and with double levered or “levered” vehicles the cost of holding is very high.
Fair value for 10-year Treasury:
Our fair value for the 10-year Treasury today is roughly 3.50% – 4%, based on the long-run real-return of 2% for the Treeasury market and the roughly 1.5% core PCE deflator inflation gauge.
Jeffrey Kleintop, the LPL strategist had an excellent tweet this morning: he thinks that the 10-year Treasury yield is a combination of the Nominal GDP yield of 1.7% and what Jeffrey thinks is the PCE deflator reading currently of 1.2%, resulting in a fair value of the 10-year Treasury of 2.90%.
- We have built a slight inflation premium into our Treasury “fair value” calculation given the stronger economic data, and improving European and Japan economies.
- We think the Friday, Sept 6th nonfarm payroll number will be stronger than expected, i.e. above 200k. I think though we’ll need a number better than 225k to really move the 10-year Treasury yield higher;
- We think that the Fed will taper on Sept 18th, which could possibly be a near-term peak for the Treasury market, even as economic data strengthens;
- We think Merkel will win re-election on Sept 22nd, and continue the “growth over austerity” path that Germany wants the rest of the European Union to follow;
- We think the debt limit scare that the financial media is pushing will be a non-event in Late September;
- The yield curve will flatten over time, as it becomes cleare that “taper” will evolve into a change in the Fed’s monetary policy;
- The next major short-term spike in yields in the Treasury market could see us reduce our TBF weighting, and look for Inverse Treasury shorts elsewhere;
The next major move or yield spike for Treasuries will be in the shorter-end of the Treasury yield curve, in the 2 – 5 year range.
Economic growth is improving, and getting better, not just in the US but Europe and Japan;
The real challenge in the bond markets in the next few years will be to generate a positive return for clients, in a market where returns could be largely negative for long periods of time. In effect we will need to trade the bond markets, and use more of a hedge fund type approach, than a longer-term buy-and-hold approach.
As of August 30th or for August month-end close, the 10-year Treasury was down -8.8% year-to-date, while the 30-year Treasury had fallen -15.6%. The IEF (7 – 10 year Treasury ETF) and the TLT (20+ year Treasury ETF) had fallen 6.59% and 12.54% respectively, all returns as of August 30, 2013.
By the end of September these returns could look far worse, but a lot depends on the August payroll report due tomorrow.
Buy-and-hold in bond funds is dead. Buy-and-hold in the US equity market is back in vogue.
(These positions could change at any time.)
Manage your exposure accordingly.
Eventually, we will move all client accounts to individual municipal and corporate bonds for client accounts and laddering the accounts to minimize most interest rate risk, but we’d like to see the 2-year Treasury yield move to above 1% (currently yielding 72 bp’s) and preferably 2% to entice us into the shorter-end of the yield and municipal bond curves.
Thanks for reading and stopping by:
Trinity Asset Management, Inc. by:
Brian Gilmartin, CFA
Portfolio manager