Bond Market Analysis

January 24, 2013

Low interest rates have put a major crimp on those seeking income.
-Barry R. James, president and portfolio manager, James Investment Research

Bond prices edged higher last week, but it wasnít much. It certainly didnít make up for earlier losses this year. Only muni bonds and hi yield bonds have advanced this year. Of course, munis were helped when tax rates rose. Hi yield bonds, on the other hand, tend to reflect the movement in stocks more than interest rates. It isnít a surprise that yields on hi yield bonds are at the lowest level in years. They are also much closer to the yield on treasuries than they have been and donít offer a lot of value.

Low interest rates have put a major crimp on those seeking income. The Federal Reserve has tried to force investors into higher risk assets and they have been successful. This is one reason hi yield bonds and stocks have been doing well. The FEDís quantitative easing is currently running at a robust pace, about $90 billion a month.

However, bonds havenít been responding the way the FED would like to see. As we pointed out in our economic outlook, rates rose each time the FED actively bought bonds and they have done so again this time. They probably feel like they have carte blanch to do so because inflation is in check. The Producer Price Index fell slightly last month and is only up 1.3% over the last year. In addition, the Consumer Price Index was unchanged last month and only up 1.7% year over year. It may not happen soon, but the best time for bonds is when the FED ceases quantitative easing, and we are starting to hear a few FED governors starting to grumble.

Some have feared another repeat of 2011 and the debt ceiling crisis. We are already living on borrowed time, as the treasury is borrowing from funded accounts to offset the spending that would take us over the debt limit. The House of Representatives is attempting to come up with a plan that temporarily extends the debt ceiling and yet forces the Senate to pass a budget. This may be difficult, since the Senate has avoided their legal duty for almost 4 years. Conveniently, Congress wrote the law with an exemption Ė no penalties for breaking the law. However, you can bet any budget the Senate passes will have a good dose of new taxes and a light dose of spending cuts. This, in the end, will contribute to the ultimate bear market in bonds as we seem likely to follow the same path as Europe.

In spite of the negative sentiment toward bonds, our indicators are actually improving. We may well get another rally in bonds, which would take everyone by surprise. If the year follows the normal pattern, the economy and stocks should cool off and bonds may once again bring life to a balanced portfolio. We continue to favor high quality bonds and would look for opportunities to increase maturities.