Bond Market Math (Conclusion)

So how do we put it all together?

Bond investors need to understand broad trends in the economy and the markets in order to invest profitably. It’s clear that the economy continues to expand, in spite of the drama we’re seeing in Washington. Interest rates are moving higher. Corporate balance sheets are healthy, and companies are expanding in emerging economies.

So the right way to invest in bonds is to own bonds that either mature or reprice sooner than the benchmark; that have exposure to corporate expansion, and that have embedded options that will expire worthless. Taking modest credit risk in a portfolio is a sound strategy—but a limited one. The spreads of the most stable global corporations are quite narrow. For example, 5-year Coca Cola bonds only pay about 0.30% over Treasuries. Still, investing can be a game of inches.

Floating-rate debt can keep a portfolio’s duration short. But be careful! Longer rates have gone up, but short-term rates may be anchored for a while. Mortgages have embedded options, because homeowners can refinance whenever they wish—but don’t when rates go up. Structured Mortgage-Backed Securities pay high current coupons, although we don’t know what Congress may do to reform Fannie and Freddie. The mortgage giants are the gifts that keep on taking—and taking, and taking.

Finally, good old callable bonds—issued by Agencies and Corporations—are less likely to be called now than they have ever been. When rates rise, those calls become useless to the issuer.

Keeping a portfolio short; taking prudent credit risk; writing value-free options—combining these strategies should give bond buyers the income they need to outpace gradually rising rates. The Fed has said that it wants higher inflation, and the Fed eventually gets what it wants. Long-term investors should be prepared.

Douglas R. Tengdin, CFA

Chief Investment Officer

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