David Fabian: With nearly everyone’s eyes on the government shutdown and looming debt ceiling deadline, the bond market has been making some subtle moves over the last four weeks. The September announcement by the Federal Reserve that they are full steam ahead on their asset purchase programs caused a snapback rally in nearly every fixed-income sector.
Prior to that event, interest rates had been on a meteoric rise that rivaled any such bond market volatility since the mid-1990’s. That caused many income investors to shun their beloved bond ETFs and mutual funds in favor of cash, dividend paying stocks, or other short-term instruments. However, we are starting to see a semblance of order return to bonds that should be evaluated in the context of whether or not this is a short-term gift to be sold or an intermediate term opportunity to be captured.
The answer is not as easy pointing to one or the other. Each sector of the bond market offers its own unique opportunities and risks that ripple beneath the surface like a shadowy predator. By analyzing areas of strength and weakness, we can determine what segments offer the best value given the amount of interest rate, credit, and other risks.
1. High Yield Continues Its Hot Streak – One area of the bond market that has been on fire this year is short-duration high yield bonds which have continued to crank out substantial income with low volatility. One of my favorite ETFs to access this space is via the PIMCO 0-5 Year High Yield Bond ETF (NYEARCA:HYS) which is currently trading near its 52-week highs. The current yield on this ETF is 4.39%.
The advantage of choosing shorter duration high yield is that you are further insulated from interest rate risk in the event that we see another move higher in bond yields. The greater danger to this sector is a stumble in the economy which would deteriorate the credit fundamentals of the companies that issue high yield bonds. That is why I am avoiding longer duration securities such as the iShares High Yield Corporate Bond ETF (NYSEARCA:HYG). Right now, the benefit of a slightly higher yield just does not match the risk of a more substantial price decline in the event that this sector falls out of favor.
2. Mortgage Bonds On The Move – One of the areas of the market that was first to begin warning us of potential danger on the horizon back in May were mortgage backed securities. The iShares MBS ETF (NYSEARCA:MBB) is one of the larger proxies for this market with over $5 billion in total assets. The bonds held within this portfolio (along with treasuries) are some of the very securities that the Fed has been buying to keep interest rates artificially low.
Since the September decision by the Fed not to taper these asset purchases, MBB has been off to the races and is now trading very close to its long-term 200-day moving average. If this fund can climb above that technical level, it may set the stage for a larger comeback in mortgage securities that would lure additional money back into this space. I typically prefer to play this sector through the expertise of an active manager such as the Doubleline Total Return Fund (DBLTX). I have found the expertise in research, security selection, and risk management to be well worth the slightly higher management fee.