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How the Market Works

Ah… The Bond Market

Posted by kdadmin on January 31st, 2013.

Ah the bond market. Loved and hated. Hated and loved. Well, you get the idea.

Bonds have traditionally been a wonderful place to wait out a stormy market. Just take a look at the attached graph of the last five years. The shaded region is a bond fund that invests in high yield bonds (PHYTX), the brown line is the S&P 500, The green line is a bond fund that invests in high quality intermediate term bonds (PTTRX) and the red line is a bond fund that invests in high quality inflation protected securities (PRRIX).

These screenshots are taken from Yahoo Finance as of close of business on January 28, 2013.

As you can see, when the S&P 500 was getting hammered in late 2008, the intermediate bond fund (green line) was doing much better, while the more aggressive high yield (shaded) and inflation protected bonds (red) weren’t doing as well. However, they were still doing much better than the S&P 500. Everybody arrived at about the same place in early 2011 before the inflation protected (red) and intermediate term (green) bonds ticked slowly upward. The S&P 500 and high yield bonds were off to a rocky start but have done much better as of late.

Now, let’s compress this into the last three months. Notice anything different? While the S&P 500 takes off to a 6% gain, the high yield bonds (shaded) do roughly 2%, and the inflation protected and intermediate term both drop by 4%. I bought high yield bonds and the S&P500 for most of you right around November 7th because the leading guidance and macro economic indicators were calling for a compression of the bond yield (falling prices of intermediate term high quality bonds), an escalating stock market and a much more gradual drop in higher yielding bonds. It proved to be a good bet. Nothing like 2% in a bond in three months…

Aside from tooting my own horn and reminding you to TELL ALL YOUR FRIENDS ABOUT ME…

My point is to offer a lesson on perspective. Every dog has its day. High quality (intermediate term and inflation protected) bonds tend to do better in declining stock markets where the leading indicators and guidance are getting worse. Higher yielding bonds tend to do better in improving stock markets (at least until inflation kicks in or the Fed increases interest rates – more on that in a minute). Now that all of the leading macro indicators are pointing / trending (albeit very slowly) in the right direction, does this mean we should dump all our high quality bonds and go head long into high yields and stocks?

Probably not.

You see, we’re at record highs. The S&P 500 hit 1500. The DOW is close to 14,000. Oh, and then there’s the drastic slow down of high yield bond purchases in Asia. So, much as it goes against every fiber of my Viking heritage, I’m going to suggest moderation. Ugh. I hate that word.

But smart money says it’s time to trim the intermediate term high quality bonds in favor of shorter term high quality bonds; to go back to the days of using bonds as a hedge. Sitting in high yield for a bit longer is still likely profitable, especially with those funds that have convertible bonds (bonds that can change into stocks), but six months is probably the outside. (High yields usually have a short shelf life.) Then easing further out of our value stocks and adding a bit more into the growth side.

My objective, as always, is to eek out as much return per unit of risk while keeping your portfolios well balanced for the long haul.

It’s times like these that making the right call is so tough. To trust the indicators in spite of market highs, to watch the Feds to be sure they’re sticking to their timeline of keeping rates steady until late 2014, to track the bond yield spreads, and to do the rain dance for a bit of wisdom in Washington; takes patience and grit.

I prefer grit. Luckily, I can hire patience.

As always, call me with questions.


p.s. The Feds announcement was, essentially, “steady as she goes.” It’s nice to have a Fed call without mass hysteria once in a while.


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