Is 2012 a good year to invest in bonds?

Introduction
This report attempts to give all the relevant information on bond investing in 2012. The focus is not on the global bond market, rather on the U.S. bond market. Within the U.S. Bond market, special attention will be given to the main bond types - Treasury bonds, corporate bonds and municipal bonds. Other bond types reasonably follow the same analysis. When it comes down to investing in bonds, factors like individual or institutional appetite for risk, investment horizon, investment goals, required return are important to the investment decision. The assumptions on these will be dynamically considered throughout the report as appropriate. In summary, 2012 will be a frustrating year for existing and potential bond investors much like 2011. The tradeoff between value and volatility is great. The economic outlook has multiple angles of interpretation, with weakly positive sectors in employment and fragile sectors in housing and consumer spending. The skepticism that the European sovereign debt crisis worst scenario is over also complicates the investment decision. The analysis points that 2012 can still be a good year for bond investment, if investors are prepared to overlook the many short term market turmoils that are bound to occur and focus on the long term value returns. The wisdom lies in balancing between the short term volatility and the long run value.

The General Economic Outlook for 2012

Real GDP Growth Beginning with the most important economic indicator - the Real GDP. Figure 1 shows the Real GDP growth for the U.S. in 2011, 2012 and 2013. The U.S. Economy is forecasted to grow at a modest 2.4% in 2012 compared to 1.7% last year. The decomposition shows that most of the increase in growth will be attributable to the strengthening retail sector, increasing consumer spending and residential construction. Business investment is set to slow down to 6.3% compared to 8.7% last year. Exports to the Eurozone are also forecasted to fall in 2012 due to the possibility of a slump. Holding everything constant, a higher expected growth rate in RGDP is not good for the bond market. This is because investors fear that the Federal Reserve may step in to increase interest rates and constrict money supply for curbing possible inationary pressures, thus lowering the prices of bonds. However, in this case the expected growth rate is very small, at 2.4% there is virtually no risk of an increase in interest rates by the Fed (which is conrmed in the statements it released) so investors need not worry. Real GDP Growth 3%

2.25%

1.5%

0.75%

0% 2010

2011

2012 (forecast)

2013 (forecast)

Fig. 1 Economic Outlook, RGDP (BMO Capital Markets, 2012)

Ination Rate The ination rate for 2012 is forecasted at 1.9% for the GDP Price Index and 2.4% for the CPI, being a fall of 0.2% and 0.7% respectively from the 2011 rate (see Fig. 2). If the forecast is accurate and we hold all other factors constant, investors in bonds this year will receive a higher real return than last year. An important point here is the goal of the
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investor. If the investor is looking to stay ahead of ination and reap higher real returns rather than simply preserve capital, the low yield robustly rated bonds (munis and treasuries) are not good options. To crank up return above 2.4% ination predicted this year, the investor will have to add high yield bonds to his portfolio. GDP Price Index 4% Consumer Price Index

3%

2%

1%

0% 2010

2011

2012 (forecast)

2013 (forecast)

Fig. 2: Ination Data and forecast (BMO Capital Markets, 2012)

Key Rates The minutes from the latest meeting of the FOMC of the Fed show that Fed isn t going to change the (very important) target federal funds rate which stands at 0.25% (the current average is 0.13%, shown in Fig.3) throughout 2012-2014. The reasons being that the economic outlook had improved albeit slightly, and to support a stronger economic recovery the Fed has decided to be keep the accommodative stance on monetary policy (Fed, 2012). Holding every factor constant, this is good news for bond investors as there is less reason to worry about higher interest rates causing capital losses, heavier for the long horizon investors.

Fig. 3: Federal Funds Rate (Federal Reserve Bank New York)

The other key rate is the yield on 10-year Treasury notes. The WSJ forecasts it to keep increasing at small increments throughout 2012 onwards as seen in gure 4. The higher yields correspond to the higher expectations of a positive economic outlook (lower unemployment and higher RGDP), but this lowers the bond prices, causing capital losses for the investors. Using this forecast in isolation, bond investors would be better off not holding bonds this year, rather shorting them as yields are expected to rise.

Forecasted Yield on 10-Year T-Notes

3.17%
3.2%

2.89%
2.9%

2.55%
6% 2.6% 2.3% 2% June 2012

2.4%

Dec 2012

June 2013

Dec 2013

Fig 4: Forecast on 10-Yr T-Notes (Wall Street Journal Survey)

Specic Bond Considerations

Municipal Bonds The market for municipal bonds in the U.S. is huge at around $3.7 trillion. In recent news the bonds issued by municipals have come to default due to mismanagement of funds, low revenue streams and fraudulent cases. Last year, we saw the biggest bankruptcy protection led by Jefferson County with debt over $1 billion. According to Bloomberg, major stakeholders in the county s debt - banks, individual investors and insurance companies suffered hundreds of millions of dollars in losses. This wasn t an isolated case because bankruptcy protections of a smaller magnitude were led for by other cities such as Pennsylvania, Rhode Island and Idaho. The CEO of JPMorgan Chase & Co. expressed his concerns saying that the we are yet to see more lings this year and warned that care must be taken before investing in municipals (Bloomberg, 2012). A higher default risk soars the yields by increasing the risk premium required by investors, thus lowering the muni bond prices and causing losses to the holders. Given this information, prospective investors would do better shorting muni bonds this year if their risk appetite is high enough, or rather stay away from them in totality to be safe. On the other hand, not all muni bonds are facing a high default risk. The major attractiveness of these bonds is their tax exemption. The example below shows this advantage of muni bonds for 2012 with a prospective investor being a couple with $250,000 (33% tax) in annual taxable income. Fig 5: Annual Payroll Tax Rates

Source: Department of the Treasury Internal Revenue Service Publication 15

If the couple plans to choose between investing $50,000 in a muni bond yielding 3% (according to Bloomberg Municipal Bonds data) or a corporate bond that yields 4% (Bloomberg Investment Grade Corporate Bonds), the income received will be $1500 from the muni bond and $1340 (after tax) from the corporate bond. Whether the tax advantage of $160 is enough to offset the higher risk of default from muni bonds will depend on the couple s appetite for risk.

U.S. Treasuries Information on whether to invest in U.S. Treasuries is varied and depends on the specic needs of the investor. Going back a few months, the U.S. Treasury ratings were downgraded by both Standard and Poor s and Moody from AAA to AA+. In a statement released last year, S&P said, our lowering of the rating was prompted by our view on the rising public debt burden and our perception of greater policymaking uncertainty (S&P, 2011). The statement also added a further downgrade would be imminent within the next 2 years if we (S&P) see that less reduction in spending than agreed to, higher interest rates, or new scal pressures . What this means for the prospective investor this year is that the U.S. Treasuries are no longer 100% default free and care must be taken before investing. Another downgrade this year is unlikely, but cannot be ruled out. If it does happen however, we will see higher yields as investors shift holdings from Treasuries to possibly other AAA bonds, slashing down the Treasuries prices and causing capital losses to its holders. Another consideration before investing in Treasuries this year is the ight-to-quality feature of the Treasuries. As the European sovereign debt crisis unfolded and reached acute levels last year, investors shifted funds into the U.S. to avoid any possible losses from default leading to a hike in prices of Treasuries and a subsequent decline in yields. Earlier this year, the Greek government arranged a debt swap to steer clear of default, which according to Reuters was successful last month (March 9) cutting the debt level by 105 billion, securing a 130 billion rescue package and projected to reduce the debt to 120% of GDP in 8 years. The implications of this on investing decisions is that the ight-to-quality effect of Treasuries is now weakening, and investors are moving funds into more risky assets (Reuters, 2012). Holding every factor constant, U.S. Treasuries lose demand, decline in price and yields soar - denitely not good for any investor wishing to maximize total returns this year. Corporate Bonds Starting with the investment grade corporate bonds (S&P AAA to BBB), the performance so far and investor outlook is positive. This can be analyzed in conjunction with the U.S. Treasuries and the ight-to-quality effect. Corporate bonds are riskier, but there is a rush among investors to reap the higher yields offered due to the positive economic outlook of the U.S. economy. This rush into corporate debt pushes prices up, and lowers yields. The higher performance of investment corporate bonds is conrmed by many sources. Fig. 6 and 7 show this development. In Fig. 6, the increase in price of the Barclays Investment Grade Corporate Bond Fund (LQD) is sustained for the past 3 months, while Fig. 7 shows the fall in yields since January. Investors should get on board corporate bonds if the trend is to continue. Credit ratings and default rate are also key issues in corporate bond investment especially high yield junk bonds. Investors opting for safety should generally stay away from these bonds. However, according to Moody s Investors Service (March, 2012) the default rates of junk bonds issued in the U.S. will be steady throughout this year at 2.2%, which falls short of the long-term default rate at 4.6%. S&P estimates are almost equal, at 2.38% for March. This risk of default compared with the average yield for junk bonds standing at 7.25% (Bloomberg High Yield Corp Index), which is about 3.3 percentage points higher than its investment grade counterparts, it could be a worthy investment for the high risk appetite investors. For the more conservative investors, I would still advice a small apportionment of these bonds to boost returns.
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Fig. 6. iShares iBoxx Investment Grade Corporate Bond Fund prices. Source: Yahoo! Finance. The thin green line is the moving average, showing a possible increase in performance.

Fig. 7 Effective Yield of Investment Grade Bonds. Is this fall sustainable?

Other Financial Markets

U.S. Equity Markets To get an idea on the relative performance of equity markets, the best index to use is the S&P 500 (GSPC) which comprises of the 500 most traded stocks in the U.S. Fig. 8 shows the performance of the stock market since the beginning of 2012. As an aid, the relative performance of the bond market, as captured by the Barclays Aggregate Bond Fund (AGG) is plotted on the same gure. The stock market started the year almost on par with the bond market, with returns in early January being almost 0% for both markets. However, during the year, we observe a yawning gap between the two markets, the stocks taking the lead and easily earning almost 8 percentage points above the bonds. The reasons for this are many, one being the reaction of the stock market to the merry news of the U.S. economic outlook this year. The bond market has underperformed quite badly in comparison to the equity market and investors should be careful of this general trend.

Fig 8: S&P 500 versus the Barclays Aggregate Bond Fund. The funnel like shape shows the weak performance of bond market so far this year. (Yahoo! Finance)

European Bond Markets European bonds have had a boosted start this year, mainly due to the efforts to reduce the debt burdens last year. We can get the picture by watching the average euro bond movement as captured by the Barclays Euro Aggregate Bond (IEAG) in Fig. 9. The euro bonds took a steep fall during the last two months of 2011, with the average U.S. Bonds always above the euro bonds. However, European bonds started crawling up with the announcement of successful swap programs and new measures to cut back debt. This upward movement continued till February this year, when the euro and U.S. bond markets were on par. Surprisingly, the euro bond market outpaced the U.S. bonds, as investor outlook on a bleak euro future improved. For the prospective bond investor, the euro zone troubles are steadily reducing this year. With the outlook of U.S. bonds generally weak, the European bond markets would be a worthy alternative.

Fig. 9: The U.S. versus the Euro bond markets. Last year gures show the superior performance of the U.S. But are the euro bond markets coming up? (Yahoo! Finance)

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Concluding Remarks
Past performance is not always a good indicator of future performance. It is simply a starting point. Bond markets may have performed well in the past, and they could equally perform poorly in the future. The number of variables to consider is just too many and it is impossible to capture all factors that would affect the bond market. As I have stated in the introduction, bond investment in 2012 is as discouraging as it was in 2011. My recommendation is that the bulk of bond investment be in selected investment grade bonds and the highest rated junk bonds. U.S. Treasuries, even with their safety haven status don t offer high enough returns to be a serious investment, given that they don t even beat the expected ination rate. Municipal bonds have had many mismanagement issues lately, though not all of them. An apportionment of these would be for the purposes of diversication. At the same time, investors need to monitor the European situation closely - the worst may be over, but we can only wait and see. There is also a possibility of another round of quantitative easing by the Fed, if actual growth rates are weak.

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References:
Bloomberg (2012) Jefferson County Alabama Files Biggest Municipal Bankruptcy. [online] Available at: http://www.bloomberg.com/news/2011-11-09/alabama-s-jefferson-countyles-for-u-s-s-biggest-municipal-bankruptcy.html [Accessed: 3rd March, 2012]. Bloomberg (2012) JPMorgan's CEO Dimon Says More U.S. Municipalities May File for Bankruptcy. [online] Available at: http://www.bloomberg.com/news/2011-01-12/jpmorgan-sdimon-says-he-expects-more-municipal-bankruptcies.html [Accessed: 1 April, 2012]. Bloomberg (2012) U.S. Government Bonds, Treasury & Municipal Bond Yields. [online] Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/ [Accessed: 19th March, 2012]. Bloomberg (2012) US Corporate Bonds Indexes. [online] Available at: http:// www.bloomberg.com/markets/rates-bonds/corporate-bonds/ [Accessed: 19th March, 2012]. BMO Capital Markets Economics (2012) United States Economic Outlook. [online] Available at: http://www.bmonesbittburns.com/economics/forecast/us/usmodel.pdf [Accessed: 10th March, 2012]. Board of Governors of the Federal Reserve System (2012) FRB News and Events. [online] Available at: http://www.federalreserve.gov/newsevents/press/monetary/ monetary20120221a1.pdf [Accessed: 18 March 2012]. Federal Reserve Bank of St. Louis (2012) BofA Merrill Lynch US Corporate Master Effective Yield (BAMLC0A0CMEY). [online] Available at: http://research.stlouisfed.org/ fred2/series/BAMLC0A0CMEY?cid=32347 [Accessed: 29 March 2012]. IRS (2012) Forms and Publications. [online] Available at: http://www.irs.gov/pub/irs-pdf/ p15.pdf [Accessed: 20th March, 2012]. Moodys (2012) US Corporate Default Rates Hold Steady Despite Broader Market Volatility. [online] Available at: http://www.moodys.com/research/Moodys-US-Corporate-DefaultRates-Hold-Steady-Despite-Broader-Market--PR_241252 [Accessed: 1 Apr 2012]. Reuters (2012) Bond bears growl again as U.S. yields surge. [online] Available at: http:// www.reuters.com/article/2012/03/19/us-usa-markets-bonds-bearsidUSBRE82I0G620120319 [Accessed: 30th March, 2012]. Reuters (2012) Greece averts immediate default, markets skeptical. [online] Available at: http://www.reuters.com/article/2012/03/09/us-greece-idUSBRE8270FH20120309 [Accessed: 16th March 2012]. Standardandpoors (2012) The U.S. Corporate Default Rate Declined Slightly In February To An Estimated 2.33%. [online] Available at: http://www.standardandpoors.com/ratings/ articles/en/ap/?articleType=HTML&assetID=1245329885618 [Accessed: 25 March, 2012].

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Standardandpoors (2011) United States of America Long-Term Rating Lowered To 'AA+' On Political Risks And Rising Debt Burden; Outlook Negative. [online] Available at: http:// www.standardandpoors.com/fgr_article/en/ap?object_id=6802837&rev_id=2 [Accessed: 5th March, 2012]. The Wall Street Journal (2012) Economic Forecasting. [online] Available at: http:// online.wsj.com/public/page/economic-forecasting.html [Accessed: 15th March, 2012]. Yahoo! Finance (2012) S&P 500 Index Chart - Yahoo! Finance. [online] Available at: http:// nance.yahoo.com/echarts?s=%5EGSPC+Interactive#symbol= %5Egspc;range=1d;compare=lqd +ief;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=und ened; [Accessed: 5 Apr 2012]. Yahoo! Finance (2012) iShares iBoxx $ Investment Grad ETF Chart. [online] Available at: http://nance.yahoo.com/echarts? s=lqd#symbol=lqd;range=6m;compare=;indicator=volume;charttype=area;crosshair=on;ohl cvalues=0;logscale=off;source=undened; [Accessed: 5th April, 2012]. Yahoo! Finance (2012) ISHS BC EUR AG EUR ETF Chart. [online] Available at: http:// nance.yahoo.com/echarts? s=IEAG.L#symbol=ieag.l;range=6m;compare=;indicator=volume;charttype=area;crosshair =on;ohlcvalues=0;logscale=off;source=undened; [Accessed: 5th April, 2012].

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