A bond picker’s market: Bubble or not

High levels of correlation in the U.S. stock market have made picking individual stocks increasingly difficult

The following is a market commentary by John Radtke, president of Incapital LLC, a securities and investment banking firm based in Chicago, Boca Raton and London.

High levels of correlation in the U.S. stock market have made picking individual stocks increasingly difficult. Recent studies indicate that about 80% of price action in the majority of widely traded stocks is closely correlated to a related index.
Are bonds different? While fixed income securities trade in correlation with similar bonds under most market conditions, ‘bond-picking’ may be as important as ever. Why?
First, let’s consider whether bonds are trading in a euphoric market. The warnings in the financial media of a bond bubble are more intense than ever. Dozens of high profile prognosticators are saying that there is more upside risk to interest rates than downside reward. While that may prove to be a reasonable forecast for new buyers of long term U.S. Treasuries, low rates do not necessarily create bubble conditions in the greater fixed income universe.
A bubble occurs when investors pile into an asset class irrationally. When calmer heads prevail, liquidation occurs and the bubble bursts. However, a strong case can be made that many bond types, structures and maturities do not meet the test of bubble-like irrationality.
Although interest rates in the U.S. are historically low, the prospect of further quantitative easing from the Fed, low inflation and slow job growth are keeping rates in check across the yield curve. Assuming that rates will stay range-bound for an extended period of time, cash may not be the optimal place to wait.
The longest end of the curve is also suspect, as a 100 basis point rise in long term rates would result in 10+ point price declines on some bonds. While a 30-year bond may lose 12 points worth or principal value for a 100 basis point rise in rates, a 10-year bond may lose 7 points, a 5-year bond 3 points and a 2-year bond only about one point.
A laddered portfolio of individual bonds can include mid-range maturities without taking on excessive interest rate volatility. Out to 10-15 years, investors can pick up 75% of the slope of the curve without incurring the volatility of the very long end of the curve.
A well researched bond portfolio with staggered maturities and bond types might consist of a mix of callable, non-callable, market-linked and step-up securities. On the shorter end of the curve, a laddered portfolio of one to five year CDs is one way to generate income and liquidity for reinvestment.
In the middle of the curve, picking municipal, GSE or corporate bonds presents a range of options that need not be intimidating. With a modest amount of extra work, advisers with bond expertise can differentiate themselves from those that rely on bond funds or ETFs.
New issues are one convenient way to access individual bonds. Alternatively, the following bond-picking tips are guidelines for finding value and efficient execution in secondary market bonds:
• Utilize online trade data (e.g. TRACE & MSRB) to compare bid & offer prices with other prices for a specific bond, or search for comparable bonds.
• When buying, evaluate yield to maturity or yield to call relative to recent new issues.
• When selling, put bonds out for competitive bid via several broker-dealers or multi-dealer platforms. Ask for the number of bidders plus the cover bid price to get a real sense of the fairness of your price.
• Larger lot sizes get better reception than odd lots. For example, $50,000 lots trade tighter than $10,000 or $15,000 pieces.
• Creditworthiness is dependent on what ultimately backs the bond – e.g. revenues or taxes for munis vs. an unsecured debt obligations of corporate issuers.
• Be aware of what a premium coupon means, or if a discount coupon is so low that it may create an unexpected tax liability.
Bond pickers can find further guidelines for building diversified bond portfolios on sites such as investinginbonds.com and incapital.com.

Incapital underwrites and distributes fixed income securities and structured notes through over 900 broker-dealers, advisory firms and banks in the US, Europe and Asia. Any opinions expressed in this article are not necessarily the views of Incapital LLC.