Money Matters: The end of the bond boom?

By Robert Smith

The Daily Record Newswire

While the stock market remains a volatile and unrewarding place, bond buyers have enjoyed one of the longest and strongest bull market runs in history. Of course this is in large part because of the Fed's extended zero interest rate policy.

These outsized returns on normally staid fixed-income investments have been driven by the huge inflow of cash into bonds by investors seeking higher rates of return.

Because of ultra-low interest rates, people are receiving horrible returns from certificates of deposit and money markets. So they have pursued bonds and created a sharp, albeit temporary, spike in demand.

The biggest immediate concern for bond buyers must be the effect that debt markets will reflect once the Federal Reserve stops buying long-term treasuries at the end of June. It's apparent that the stock market is not happy about it.

The Fed's QE2 program has kept long-term rates way too low for way too long.

What will happen to long-term rates when the Fed steps out and no one or nothing steps in to pick up the slack? They should go up. Therefore, in theory these rates should begin to rise in July. As rates rise, bond values will go down.

The only way for fixed-income investors to protect themselves against this is to diversify via a number of portfolio "drivers" (diverse income-generating securities) so that no single adverse economic event can destroy overall portfolio performance.

Because of the inevitable increase in long-term rates, a portfolio's first allocation should be to some form of adjustable rate debt security.

These securities will ultimately benefit from any rise in long-term rates. However, this usually comes at a cost to the investor of 1 to 2 percent in current yield.

When selecting said securities, look for something tied to the headline consumer price index rather than the core CPI, which intentionally lags the true inflation rate by a significant amount.

As such, Treasury TIPS are not the best choice here, but those who like them may wish to consider the ETF iShares U.S. Treasury Inflation Protected Fund.

The next sector I would recommend is oil.

Despite recent sharp price decreases, the oil market is still very bullish. Unrest is still rampant throughout North Africa and the Middle East, but oil demand in emerging markets overseas will continue to grow.

I would take advantage of the current dip in prices to buy Canadian oil and gas producers. Lower prices mean high yields.

Finally, I would continue to invest in stock market-linked securities with high yields such as preferreds and convertibles. Despite the market's negative tenor, it is extremely oversold.

I also think it is a poor idea to sell both equities and commodities going into an election year. The powers that be will pull out all the stops to make those most likely to vote feel richer rather than poorer.

This means another round of quantitative easing, or QE3, cannot be ruled out.

Even though he is clearly no student of history, President Obama must be familiar with George Herbert Walker Bush's famous outgoing quote regarding Fed Chairman Alan Greenspan: "I appointed him and he disappointed me."

So, be on the lookout for more government stimulus if the president is polling poorly going into 2012.

And never, ever fight the Fed.

Robert Smith is president of Peregrine Private Capital Corp. Contact him at 503-241-4949 or at: www.peregrineprivatecapital.com.

Published: Mon, Jul 18, 2011

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