Bond Market Down, Not Out

Something big is happening in the bond market.

After decades of reliable returns, bond value is now being undermined by an increase in interest rates, a trend many predict will last into the foreseeable future.

The most recent cycle of turbulence began in May, when Federal Reserve Chairman Ben Bernanke announced its program of buying billions in securities each month was going to be tapered back. The announcement triggered a violent reaction in the bond market — an $80-billion redemption, a sharp rise in rates and a steep drop in value.

Uncertainty over the Fed’s bond-buying program persists, and it can be seen in the interest rate. In early May, before Bernanke made his comments, the rate on a 10-year treasury was 1.66 percent. By Sept. 5, the rate had spiked to 2.98 percent. In the $38.7 trillion U.S. bond market, that’s an enormous shift.

Though Bernanke came back in September and announced the Fed was not ready to taper its bond purchases — a process known as quantitative easing — financial experts like Scott Phillips of Arvest Bank predict at some point the Fed will begin to taper and that rates will continue to rise.

The big questions are how long will they increase and how high will they go?

Phillips, a vice president and chief investment officer at Arvest in Lowell, sees a bear market in bonds. He is recommending a laddering of maturities, a transition to shorter maturities, and in some cases, a switch from bonds to cash and stocks.

“You don’t want to be over-weighted in bonds right now,” Phillips said.

The name of the game, he said, is to hang tough until better rates come around at some point in the future.

The Arvest trust division oversees a portfolio of more than $2 billion, with more than $900 million invested in bonds and notes.

When Bernanke made his comments in May and September, Phillips heard about it from plenty of people.

“I was fielding a lot of phone calls from clients,” he said.

For the last three decades, the rate for 30-year treasuries and municipal bonds trended downward, and that was good for investors because bonds are sold at a premium when the interest rate is lower than the bond’s coupon rate. In effect, the value of bonds always went up.

That’s no longer the case. When interest rates rise, as has been the case since May, bonds lose value and are sold at a discount. For investors, that’s bad news.

“We’re not telling people to sell bonds, but we are telling them to shorten their maturities,” Phillips said. “You don’t want to make big bets with bonds right now.”

 

Borrower’s Market

Financial analyst Scott Alaniz of Boston Mountain Money Management Inc. in Rogers gets straight to the point.

“It’s a borrower’s market,” he said. “Corporations are saying we have to borrow because money is cheap.”

To see what he’s talking about, one has to look no further than Wal-Mart Stores Inc. The retailer recently issued $1.75 billion in bonds, and more than half of that was issued on a five-year maturity of 1.95 percent. That’s great for Walmart, but for an investor looking for a rate of 5 percent, the Walmart bonds aren’t so attractive.

And there’s the problem.

“The interest rate is not there anymore, so when bonds mature, investors are looking at how to recreate the return on the bonds that just matured,” Alaniz said.

To do that, an investor will have to take on more risk. But on the bond side of the investment equation, Alaniz said at least for now, it’s not worth taking that risk in bonds.

Alaniz said a buyer can purchase a 30-year bond at 3.72 percent or a five-year bond at 1.42 percent. While the long-maturity bond carries a higher rate, it is also subject to the fluctuations of the market and could move 10-20 percent or more in price, and in the wrong direction, before maturity.

The message is clear.

“You’re not being compensated enough by taking the risk of purchasing long-maturity bonds,” Alaniz said.

For now, he said, short-term, low-interest bonds like the ones issued by Walmart might have to do.

“It’s not about maximizing income but minimizing cost risk,” Alaniz said, referring to the prevailing investment climate.

One day great bond rates will return, but not for the foreseeable future.

“There will be a time for that, but now is not the season,” he said.

 

Bond Issuers Refinanced

The federal funds rate, the rate at which banks lend money to other banks overnight, ultimately affects interest rates on bank loans, credit cards, adjustable-rate mortgages and securities like bonds. It is one of the most important interest rates in the U.S. economy, and though the lending rate is set by the market, the Fed determines the federal funds target range, which in turn influences the rates negotiated by the banks.

The effective federal funds rate soared to a high of 19.1 percent in June 1981, and even though the rate has fluctuated since that time, it has steadily trended downward to 0.08 percent in August, according to historical data kept by the Fed. With the effective federal funds rate at rock bottom, it can only go up — and with it all rates — and that’s what wealth managers are discussing with their clients.

As is the case in the economy, there are always at least two sides to every story. And while low interest rates mean there aren’t a whole lot of good bond deals out their right now, public entities across Arkansas and the United States took advantage of the rates by refinancing their bond issues and saving taxpayers millions in the process.

Bob Wright, senior managing director of the Capital Markets Group at Crews and Associates Inc. in Springdale, said the historically low interest rates presented a golden opportunity for issuers to repackage their debt. That opportunity was seized upon by many entities, including Prairie Grove, Washington County, Centerton, Cave Springs, Tontitown, Springdale and Beaver Water District.

Bonds are issued by governments, credit institutions and companies to raise capital. A key difference between stocks and bonds is that stocks convey an ownership interest in a company, whereas bonds convey a creditor interest. The bond is essentially an IOU with a fixed-rate coupon owed to the bond holder. When the coupon is favorable, issuers make their move.

“We got them locked in when rates were low,” Wright said. “A lot of entities took advantage of what the market had to offer.”

As an underwriter, Wright’s job is to buy entire bond issues — almost exclusively in the public sector — and then sell them on the open market. Last year, Crews & Associates underwrote 800 issues in the amount of $7.88 billion, and thus far this year, Crews has underwritten $5.6 billion in bonds.

Low interest rates drove away some investors, or, as Wright said, lots of people have been “sitting on the sideline waiting for rates to rise. It’s not been as easy [to sell bonds] and the pool of investors is not as deep.”

But the bonds still sold because they were tax-exempt public bonds, and “the need for a secure, tax-exempt form of income is still there.”

Now that the interest rate is starting to creep up, the boom in refinancing is essentially over.

“Those are pretty much done,” Wright said.

 

Enduring Dollar

Investors have to believe in capitalism. The U.S. dollar is resilient, as is a well-balanced portfolio with a bond structure that mitigates the risk of stocks, said Glenn Atkins, a bond expert at Garrison Financial in Fayetteville.

The market has been volatile since the crash of 2008, and this year, the rate surge on 10-year treasuries and the resultant devaluation was swift and destructive.

But investors have to remain calm, Atkins said, and when looking at a portfolio, an adviser would do well to focus on one simple question: “How do I get yield for my client?”

Atkins said he doesn’t look at bonds with a maturity of more than 10 years, and in many instances, no more than seven years. He also looks at short- to intermediate-term corporate bonds, which typically bring a higher yield than treasuries and government-agency debt.

On the stock side, Atkins works closely with the firm’s president, Kerry Watkins Bradley, to ensure a thorough apportionment of a client’s assets.

“If it happens steadily over a few years, it’s definitely a good thing,” Atkins said. “If the rate doubles tomorrow, that would be painful.”