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TAPER, TAPER, TOIL & TROUBLE

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Not to be confused with a tapir, which is a large browsing mammal similar in shape to a pig that roams the jungles of South America and Southeast Asia.

Tapir

The word taper or tapering has received a whole lot of attention lately after Ben Bernanke announced at the latest Federal Open Market Committee (FOMC) meeting in June that the $85 billion of bond buying occurring each month a.k.a. QE III (Quantitative Easing) may start to be reduced or “tapered” in the near future. His announcement sent the stock and bond markets reeling as market participants feared that the easy money, very low interest rate environment of the last few years may be about to change.

The Federal Reserve has been embarking on the stimulus programs known as QE since the depths of the market crash in early 2009 in an attempt to assist the weakened U.S. economy to recover from the Great Recession. Buying short and medium term treasury and Mortgage Backed Bonds from the large banks has allowed Bernanke to keep short and medium term interest rates at a very low level. This has encouraged investors to take on more and more risk by buying stocks and other riskier assets as the returns on “safe” assets such as Treasury Bills and CD’s have fallen to virtually nothing.

Why did Bernanke suggest that he may “taper” the bond purchases? Well, in the long run, it is good news, because he feels that the U.S. economy is improving to the point where it does not need as much help from the Federal Reserve and is close to standing on its own two feet. He is looking at the Headline Unemployment rate dropping to 7.6%, and housing improving rapidly as two of his main indicators.

Unemployment Rate

 

HOUST

HOUSING STARTS SINCE 2010

Bernanke suggested that the reductions in the bond purchases could begin as early as September and cease altogether by sometime in 2014, but that it will all be dependent on the data (unemployment, housing, etc.) that comes in over the next few months. In all the commotion, though, investors reacted as though Bernanke said QE was ending immediately and that they would be raising short-term interest rates in the near future. However, other Federal Reserve members have since made comments that imply the market has over-reacted to what Bernanke said.

Jeremy Stein, a member of the seven-person Fed board of governors said in a speech on June 28th,

“Consumers and businesses who look to asset prices for clues about the future stance of monetary policy should take care not to over-interpret these movements” because they have been larger than justified by what the Fed said, Mr. Stein said.

As several other Fed officials stated this week, Mr. Stein stressed that Mr. Bernanke’s statements in no way reflected a shift in the Fed’s plans for raising short-term rates, which have hovered near zero since late 2008.

Source: http://blogs.wsj.com/economics/2013/06/28/feds-stein-adds-to-chorus-saying-markets-misread-bernanke/

Mr. Stein was not alone in implying that investors in the stock and bond markets were over-reacting to the tapering that Mr. Bernanke was referring to. Other FOMC members also voiced similar comments. New York Fed President William Dudley said that QE3 would continue at a higher pace for longer if growth and labor miss forecasts. Even Dallas Fed President Richard Fisher, a well-known critic of QE3, had similar comments and stressed that the wind-down process will be gradual and cautious and that the markets may have overreacted.

Source: http://money.cnn.com/2013/06/27/news/economy/federal-reserve-dudley/index.html

WHY DID BOND YIELDS SPIKE UP?

After Bernanke’s comments at the June FOMC meeting, bond yields spiked up as bond market investors rushed to the conclusion that the Fed was ending QE much sooner than anticipated and that they would be raising short-term interest rates sooner as well. Since the Fed has been buying a huge percentage of the available Treasury and Mortgage Backed Bonds from the banks the last few years, it has kept short and intermediate interest rates very low because there has been this constant demand for bonds from the Fed. Hence, the lousy rates on your CD’s and money market accounts. The fear in the market is that if the Fed is reducing or stopping the bond purchases soon, that demand will drop and rates on bonds will have to rise to entice investors. Plus, a stronger economy would also cause rates to rise as chances for inflation increase.

10 YR Treasury Bond Maturity Rate

YIELD ON THE 10 YR U.S. TREASURY BOND SINCE JAN 2013

This surge in bond yields caused many bond investors to rush for the exits at the same time in a panic and caused the prices of virtually every type of bond to fall in price. It also affected any “bond like” investment, such as dividend paying stocks, utilities stocks, real estate, preferred stocks, high quality corporate and treasury bonds, junk (high yield) bonds, and emerging markets bonds. Many investments that have been safer, less volatile investments the last several years really took it on the chin in June with the quick spike in rates.

Normally, this might happen if inflation had spiked up, but inflation is running very low. In fact it is running at a very low rate largely because the economy is still “muddling through” with very tepid growth.

U.S. Inflation Rate

Historically, inflation averages around 3%, but is currently running around 1.4% or so on an annual basis. Thus, it was unusual for bond yields to spike up so dramatically without a spike in inflation. But this confirms the extent of the Federal Reserve’s influence on bond & stock prices with the QE programs.

Next, take a look at the Gross Domestic Product (GDP) which is a measure of the strength of the economy.

GDP

The most recent quarter came in at a disappointing 1.8% growth rate. A healthy economy would have a growth rate in the neighborhood of 3% to 4%. So, even though unemployment is getting better and housing is improving, there are still areas of the economy that are struggling which resulted in the tepid 1.8% GDP growth in the first quarter of 2013.

Bernanke is also concerned about tapering too soon and causing a spike in mortgage rates which might impact home buyers. The historically low mortgage rates of the last several years have been a nice tailwind to home purchases. However the recent increase in treasury yields also caused mortgage rates to move up since they are generally tied to the 10 year treasury rate. The Federal Reserve has to be concerned that this could put a damper on the housing recovery we are seeing.

As you can see in the chart below average rates on a conventional 30 year mortgage jumped from about 3.25% in April to a recent rate of about 4.35%. On a $250,000 mortgage that causes the monthly mortgage payment to jump about $156. Quite a difference!

Mortgage Rates

 

SHOULD I SELL MY BONDS AND BOND FUNDS?

The last month and a half have been very tough for investors in the bond market which normally has been a more conservative area of the financial markets. A lot of investors have panicked and sold their bonds and funds into the spike downward. Now that interest rates and the bond market appear to be stabilizing a bit, they are missing out on the potential rebound in bond prices.

However, if the economy improves, there is a good chance that over the longer term interest rates will continue to rise, so what do you do?

Bonds still play a very important role in a broadly diversified portfolio, but investors do have to be aware of the risks of the bond market and adjustments may occasionally be needed. One of those adjustments to keep bond volatility low would be to keep bond maturities relatively short. In the current environment this means keeping maturities around 5 to 6 years or so. (We will skip the concept of duration, which is beyond the scope of this article, but for those interested you can find a good definition here.) The trade off with shorter maturities is lower interest payments.

We can also utilize bond funds that don’t have to adhere to a strict benchmark ( known as “Unconstrained Funds”). These funds can adjust maturities and durations and can even structure the portfolio to take advantage of and profit from rising interest rates.

Returns can also be improved by increasing credit risk modestly through investing more in corporate bonds below AAA rating and increasing exposure to high yield bonds with lower credit ratings. These types of bonds will perform better if rates rise because of an improving economy. Opportunities in the fixed income area also include Floating Rate Bond funds. These funds invest in lower quality corporate bonds with very short maturities which reset their interest rates every few months or so. Thus, if rates rise, these funds can do well, because the bonds that are held reset to the higher interest rates relatively quickly. Again, the trade-off here is that you have to sacrifice some credit quality to get the better returns.

Finally, the higher interest rates do allow an opportunity to fill in rungs on bond ladders that have been difficult to fill the last few years because rates have been so low. When you hold bonds in a bond ladder, rising interest rates do not really affect you as much if the bonds are held to maturity, since you get the principal back plus all the interest collected over the life of the bond.