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 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 bubblelike irrationality.
Interest rates in the U.S. are historically low and the combination of further quantitative easing from the Federal Reserve, low inflation and slow job growth are keeping rates in check across the yield curve. Assuming that rates will stay in a narrow range 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 price declines of more than 10 points on some bonds. While a 30-year bond may lose 12 points in principal value for a 100-basis-point rise in rates, a 10-year bond may lose 7 points, a five-year bond 3 points and a two-year bond only about 1 point.
A laddered portfolio of individual bonds can include midrange maturities without taking on excessive interest rate volatility. 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.
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:
• Use online trade data (from the
Financial Industry Regulatory Authority Inc.'s Trade Reporting and Compliance Engine, for instance) to compare bid and offer prices with other prices for a specific bond, or to 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 multidealer platforms. Ask for the number of bidders and the cover bid price to get a real sense of the fairness of your price.
• Larger lot sizes get better reception than odd lots.
• Creditworthiness is dependent on what ultimately backs the bond, such as revenue or taxes for municipal bonds versus unsecured debt obligations of corporate issuers.
• Be aware of what a premium coupon means, and whether a discount coupon is so low it could create an unexpected tax liability.
Near year-end, current market conditions also may offer opportunities to optimize and re-balance fixed-income portfolio holdings.
• Depending on when and at what price a bond was purchased, tax loss swaps into a similar bond with the same credit and coupon could be considered. Losses potentially can be used to offset gains elsewhere, creating a more tax-efficient return.
• Upgrading the credit quality of portfolios is another possible year-end strategy. For example, municipal bond portfolios no longer have the option of triple-A insurance after the recent downgrade of Assured Guaranty. For those seeking the highest-rated backing, alternatives include pre-refunded municipals, Permanent School Fund-guaranteed bonds, triple-A underlying credits and escrow-to-maturity munis. A similar approach may be taken in corporate bonds, where credit quality can be improved by swapping into highly rated callable step-up securities or structured notes.
• In municipal bonds alone, more than $37 billion in principal and interest comes due next month. Knowing exactly what is held in a portfolio, and what comes due, is a first step in determining the available options for optimizing client portfolios in the last weeks of 2010 — bubble or no bubble.
John Radtke is the president of Incapital LLC, a securities and investment banking firm.
