US Bond Outlook

Is the corporate bond runup over?

LQD is a corporate bond index ETF. IEF is a treasury bond index ETF. I'm using these as a proxy for corporate bond and Treasury bond prices.

At the beginning of the market meltdown, there was a divergence of corporate bond prices and Treasuries, then in March 2009, prices began to converge, with Treasuries dropping and corporates rising. (Figure 1). On March 31, 2010, the 1 year return for Vanguard's intermediate-term Treasury fund (VFITX) was -0.41%, and for its intermediate term investment grade corporate bond fund (VFICX) was 21.96%.

Figure 1

from bigcharts

Historical prices suggest the runup in corporate bond prices is just about over (Figure 2). Yields would serve as a better measure, but the prices are good enough stand-ins for my purposes.

Figure 2

from bigcharts

The rise in interests rates should also adversely affect both Treasuries and corporate bonds, but an article by Vanguard argues that this would probably occur mainly with shorter-term maturities because any action by the Fed will calm fears of long-term inflation. Ok. So I'll stay out of short-term bonds.

TIPS (aka TIIS)

Vanguard also argues that TIPS might be vulnerable. One can assess the relative pricing of TIPS and Treasuries by comparing their yield spreads to the anticipated rate of inflation because the Treasuries carry inflation risk, and the TIPS do not. An expectation of high inflation should show up as a high spread, and vice versa. The current (April 22, 2010) TIPS/Treasury spread seems to be reasonable right now (2.13 for 5 years, and 2.33 for 10 years). It's true there has been a run up in TIPS, similar to the runup in corporate bonds (see Figure 3), so the TIPS party might be over, but it doesn't seem to me that they are overpriced. Moreover, since they offer inflation protection, I think they're a safer refuge in the current environment than Treasuries or corporates (but keep in mind that Vanguard disagrees).

Figure 3
(Note: TIP is a TIPS ETF)

from bigcharts

High-Yield (Junk) Bonds

Junk bonds are another, interesting, option. An asset rotation study performed by PIMCO shows historical returns of different asset classes across the business cycle. Early in the expansion cycle and in mid expansion, high-yield bonds, convertible bonds, and especially emerging market debt have done well, even beating equities! However, figure 4 below suggests the party's almost over for both convertible bonds (Vanguard's VCVSX) and high yield bonds (Vanguard's VWEHX) (Recall that IEF is an intermediate term Treasury ETF, and that LQD is an intermediate term corporate ETF).

Figure 4

from bigcharts

Another way to value high-yield bonds is through the yield spread. The typical spread has been about 300 to 400 bps over comparable maturity Treasuries (pimco). Right now, the spread is about 500 bps (see bloomberg). So it seems there's still a bit of price appreciation (about 13%) left in high yields (or price depreciation left in Treasuries!) Note how the estimate computed from yield differentials is close to the difference between the return in Treasury prices and the return in high-yield bond prices from Figure 4. The yield on Vanguard's convertible bond fund in contrast is only 3.69%, about the same as a 10-year Treasury. It's not clear, but there may not be any price appreciation left in convertibles.

High-yield default rates have also been falling, and Moody's predicts that trend will continue into 2010. Hey, it's Moody's, gotta trust Moody's, right? Of course, default rates will only continue to drop if the recovery continues.

Interest Rates

Any action by the Fed could through a wrench into all of this, causing bonds prices across the board to drop. It's worthwhile noting though that high-yield bonds act a bit more like equities having less sensitivity to rising interest rates than other bonds, because interest rates increases co-occur with falling credit risk at the beggining of a recovery. Maybe this explains PIMCO's asset rotation findings discussed earlier.

What makes me uncomfortable about this recovery is that it was fueled by government spending. It's not clear to me (and to many others) that this government spending was able to sufficiently prime the pump for the private sector to sustain the recovery going forward.

Bond Allocation

As always, in my opinion it's better to directly hold the actual bonds so that you can hold them to maturity, thus avoiding a loss on your capital. Inflation eats away at your returns a bit more, but it makes for less of a roller coaster ride. I can't do this in my Vanguard account so I'm going to modify my bond fund allocation instead.

Given, the above discussion, here's how I'm going to allocate my funds across the bond asset class. Bottom line: beware rising interest rates!

Vanguard Inflation-Protected Securities Fund (VIPSX): 30%
Vanguard Total Bond Market Index Fund (VBMFX) (holds gvt and corporate investment grade bonds): 20% *
Vanguard High-Yield Corporate (VWEHX): 20%
Vanguard Intermediate-Term Investment-Grade (corporate) (VFICX): 10% *
Vanguard Money Market (really really short term bonds): 20%

* more sensitive to interest rates.