Coming off a strong performance in 2009, the fixed income markets are going to be a whole new ballgame in 2010. In this issue of MOR Investing, our Morgan Keegan fixed income experts explain why this year it may be better to think short and high when it comes to investing in bonds. Also, our equity researchers and strategists have teamed up to achieve a significant three-peat with our Focus List—see why you have one of the best equity teams in the industry in your corner.
Investing in the Fixed Income Markets:
Look for Short Duration, High Quality
On the heels of an impressive year in most sectors of the bond market, fixed income investors face a considerably more difficult environment in 2010. The aggressive strategies and investments that benefitted from the opportunities presented by the marketplace in 2009 may not be the best way to go today. And while safer money market mutual funds and other high-quality, short-maturity instruments don’t offer eye-popping yields, those bolder strategies for generating greater income – like extending maturities or taking on greater credit risk –present risks that many investors may not fully appreciate, and probably should avoid. So how should you continue to invest in the fixed income markets?
Climb the Ladder
When it comes to investing in bonds, we continue to firmly believe in the merits of a ladder strategy for the majority of income-seeking investors. The process for constructing a bond ladder is fairly straightforward: the investor determines the maximum maturity that is most appropriate based on his or her specific investment objectives and constraints, and purchases securities with staggered maturities leading up to that final maturity date. For example, an investor constructing a $100,000, 10-year ladder today would invest $10,000 in bonds scheduled to mature in 2011, $10,000 in bonds scheduled to mature in 2012, up to the final 2020 maturity. As each “rung” of the ladder matures, the investor would reinvest the proceeds in a bond maturing one year after the final maturity – or 2021, in our example. Aside from its simplicity, the primary advantage of a ladder strategy is that it reduces the risk of underperformance due to incorrectly forecasting changes in interest rates. The performance of a laddered portfolio is less influenced by changes in interest rates than an actively managed portfolio since the proceeds of maturing bonds are being regularly reinvested.
Although we recommend a ladder strategy for most traditional, income-oriented investors, we recognize that some investors may opt to pursue a more active approach to managing their fixed income investments. To those investing for total return as opposed to current income, we offer our perspectives about risks and opportunities in the fixed income market today.
Keep an Eye on Credit Risk
In the bond market, the credit-sensitive sectors – like corporate bonds– delivered the greatest performance last year as the sense of panic during the darkest moments of the credit crisis eventually gave way to a renewed sense of optimism. Let’s look at credit spreads, or the yield differential between a bond with some degree of credit risk and U.S. Treasury securities (widely considered to be virtually free of credit risk) with similar maturities. Spreads narrowed substantially over the last year and are now at levels reminiscent of conditions immediately prior to the recession. In simpler terms, corporate bonds and the like are offering much less compensation for the credit risk they pose than they were just one year ago—and investors are apparently willing to accept that squeeze.
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| This yield curve has steepened substantially since 2007, indicated that the possibility of higher short-term interest rates may have already been priced in by the fixed income market, thus possibly mitigating the risk of substantially higher interest rates in the immediate future. |
In fact, investors, chasing last year’s performance and understandably frustrated by the diminishing yields offered by higher-quality securities, may be venturing into riskier fixed income instruments without fully grasping the potential ramifications. One only needs to look to history to see the potential pitfalls. In 2006, buyers of speculative-grade corporate bonds experienced the painful consequences of demanding too little compensation for credit risk when a credit crisis instigated a massive sell-off, often at a great loss – a fate that seems just as likely for today’s buyers of lower-quality securities. For those investing with total return performance in mind, we urge caution with respect to the lower-quality rungs of the credit market.
Thoughts on Interest Rates
In recent months, we have observed an increased interest among fixed income investors, especially individual investors, in shorter-dated maturities based on growing concerns about rising interest rates. You have probably heard the pundits and market experts (including our own Kevin Giddis on CNBC) discussing the Fed’s next potential moves, and the arguments favoring higher interest rates in the months and years ahead are rather compelling. However, we believe it is important for investors to recognize that not all points on the yield curve are equally vulnerable to rising interest rates. Predicting what the Fed will do with interest rates is often an exercise in futility, so we generally try to resist any temptation to offer formal predictions about interest rate changes. But we are reasonably confident about one prediction in particular: the Fed Funds target rate, currently standing at its practical floor of 0.00-0.25%, is not going any lower. Consequently, we feel equally certain that at some point –in 2010 or sometime later – the short end of the yield curve (which is heavily influenced by Fed policy) will eventually drift higher as economic conditions continue to improve.
What is far less certain, however, is that yields from longer-dated instruments – driven primarily by technical (e.g., supply/demand dynamics) and fundamental (e.g., inflation expectations) factors rather than Fed policy – will follow a similar course. But if forced to stake out a position on the future direction of interest rates from longer-dated Treasuries (which serve as an anchor of sorts for the broader bond market), we believe the odds favor moderately higher interest rates on the immediate horizon.
Please note that we only expect a marginal increase in the general level of interest rates, rather than a severe upward shift in the yield curve. Indeed, evidence suggests that the bond market may have already priced in the possibility that the Fed will soon adopt a more contractionary monetary policy stance. Here’s why: The yield differential between the 6-month Treasury bill and the 10-year Treasury note over the past 30 years has been approximately 155 basis points (1.55 percentage points) – a relationship that has also remained more or less intact during the past 10- and 20-year examination periods as well. Today, however, that spread is approximately 365 basis points. That’s over 200 basis points wider than the historical average. If, for instance, the Federal Reserve were to take policy actions (e.g., increasing the Fed Funds target rate) resulting in short-term interest rates increasing by, say, 200 basis points and if the slope of the yield curve reverts back to historical averages, longer-term interest rates would still remain roughly the same as they are today. In our view, given how steep the yield curve is in relation to historical averages, the risk seems low that an increase in short-term interest rates results in an equal-magnitude increase in longer-dated securities’ yields. Therefore, we are advising that you stick to the short end of the curve.
Stay Short, Reach High
If 2009 is to be remembered as a year during which opportunism proved to be the most rewarding strategy, we suspect that a more defensive stance will provide the greatest possibilities for total return performance over the next 12-24 months. As such, a strategy that emphasizes short duration and, more importantly, strong credit quality has the greatest appeal at this time. Investors should be cautioned, however, that the payoff from this strategy will likely occur at some point in the future, when a more favorable yield environment reemerges.
Still, we recognize that a short-duration, high-quality fixed income strategy may not provide the level of current income required by some investors. To investors weighing the choice between reducing credit quality and extending maturities as a means for reaching their investment goals, we have a more favorable view towards duration risk as compared to credit risk as of this writing. That is, we feel widening credit spreads are more likely to cause near-term losses than higher interest rates.
While we continue to believe that consistency is at the foundation of any successful investing plan and that there remain pockets of opportunity for enterprising income-seeking investors, we feel that investors in the fixed income market should give strong consideration to high-quality options like Treasuries. As unappealing as the prospective yield from higher-quality instruments currently may be, now is not the time to be reaching for yield in the fixed income markets.
For more information about fixed income investment opportunities, contact your Morgan Keegan financial advisor.
Put Our Expertise to Work for You
Every six months, Barron’s magazine ranks the performance of the recommended stock lists of 13 national and regional brokerage firms, including Morgan Keegan’s Focus List of recommended stocks. In the magazine’s February 1 issue, Barron’s reported that our Focus List was the top performer for total returns in the five-year category—for the third consecutive time.
According to Zacks Investment Research*, Morgan Keegan’s Focus List racked up a 28.5% return over the five years ending December 31, 2009, outperforming the recommended lists of Citigroup, Morgan Stanley, Edward Jones, Raymond James and Wells Fargo, as well as the S & P 500 Composite. You can read excerpts from the Barron’s article here.
The Morgan Keegan Focus List is created by the Focus Group, an investment brain trust consisting of representatives from Morgan Keegan’s equity research department, equity strategy group, equity institutional sales and private client group. Together, they select stocks they believe will have the best potential from the more than 300 companies followed by our equity research group.
The Morgan Keegan Focus List is not a portfolio, but a representative collection of stocks that illustrates our stock-picking ability. As a Morgan Keegan client, you have full access to the research, insight and knowledge that go into devising our award-winning Focus List. Talk to your Morgan Keegan financial advisor to learn more.
* Additional Morgan Keegan Focus List performance figures as of 12/31/09: 6-month return 24.2%; 1-year return 45.2%; 3-year return -10.6%; return since 1/1/04 64.2%. Featured in Barron’s 2/1/10.
There’s Still Time to Feed your IRA
April 15 is just a few days away, but you still have time to make contributions to your IRA and Roth IRA accounts. IRA and Roth IRA owners can make up to $5,000 in contributions to their accounts for tax year 2009, and IRA owners age 50 and over can make up to $1,000 in additional contributions ($6,000 total). You may also be able to make additional contributions to your spouse’s IRA. Just know your IRA or Roth IRA contributions must be deposited by April 15 or, if mailed in, postmarked no later than April 15. Tax filing extensions do not apply to your IRA and Roth Contributions. Morgan Keegan does not provide tax advice and we strongly suggest that you contact your tax advisor for more information. If you would like to open a new IRA or Roth IRA, convert an existing IRA to a Roth IRA, or rollover a 401(k) to an IRA, please call your Morgan Keegan financial advisor.
FINRA — Protecting You
Morgan Keegan & Company, Inc. is a member of the Financial Industry Regulatory Authority (FINRA). As such, we are required to disclose the availability of BrokerCheck, an online tool that provides information on FINRA registered securities firms and brokers. To access BrokerCheck or download a brochure, go to www.finra.org. For questions regarding BrokerCheck, FINRA provides a toll-free hotline, (800) 289-9999, available Monday through Friday from 8 a.m. until 8 p.m., Eastern Time.
Learn More About SIPC
Morgan Keegan & Company, Inc. is a member of the Securities Investor Protection Corporation (SIPC). You may obtain information about SIPC, including a SIPC brochure, by visiting www.sipc.org or calling (202) 371-8300.
News for CMO Investors
An informational brochure on CMOs and other mortgage-related securities is available from your Morgan Keegan financial advisor. Call your advisor for a complimentary copy.
An Important Message for Margin Account Holders
Customers with margin accounts that have a debit balance may lose the right to vote some or all of the securities. Securities that are pledged as collateral for a margin loan may then be lent by the Firm carrying the debt (Morgan Keegan) to itself or to others. The authorization for this lending of securities is set forth in the Morgan Keegan New Account Client Agreement and Disclosure Statement. If those shares are loaned, the right to vote the shares goes with the shares. Therefore, if you carry a margin debit balance you may not be able to vote all of those shares. Further, you may receive proxy materials that reflect a right to vote a different, smaller number of shares than you may own in your margin account.
If you have any questions on these matters, please contact your Morgan Keegan Financial Advisor.
