Markets

The Boiling Point: Fed Green-Lights Bond Market

Ben Bernanke's Humphrey-Hawkins testimony before the U.S. Congress last week saying the economic situation was "unusually uncertain" created enough uneasiness to unleash new buying in the bond market, some much like before and some with new twists.

Chadd Bennett

A slew of debt ETFs, led by the iShares JPMorgan USD Emerging
Markets Bond Fund (NYSEArca:EMB) all moved higher since the Fed
chief spoke. Others that caught a bid reflected the broad reaction
to Bernanke's comments, and included:

The U.S. Treasurys market rallied hard following the Fed chief's appearance, but has since paused and retraced slightly. But by giving bond buyers the green light, spread markets continued to grind tighter as the quest for yield in a zero-rate environment pushed on.

A slew of debt ETFs, led by the iShares JPMorgan USD Emerging Markets Bond Fund (NYSEArca:EMB) all moved higher since the Fed chief spoke. Others that caught a bid reflected the broad reaction to Bernanke's comments, and included:

  • Barclays MBS Bond Fund (NYSEArca:MBB)
  • S&P National AMT-Free Municipal Bond Fund (NYSEArca:MUB)
  • iBoxx $ Investment Grade Corporate Bond Fund (NYSEArca:LQD)
  • iBoxx $ High Yield Corporate Bond Fund (NYSEArca:HYG)
  • SPDR Barclays Capital High Yield Bond ETF (NYSEArca:JNK)

In the end, Bernanke revealed little about how monetary policy is likely to shift in the near term. But he did say future policy would most likely be unconventional, and that the central bank hasn't fully reviewed its options there.

It's nothing new really, and left the market looking to keep the rally going with a few newer ideas, including some relative-value plays. Where or how the buying ends is anyone's guess.

Newer Twists

While nothing Bernanke said suggested rates are heading higher anytime soon, some bond managers are still turning their focus toward ideas that will be more resilient in an environment of rising rates.

Cushion municipal bonds, for example, are gaining interest because of their relative outperformance in a rising rate environment. Cushion bonds are those that are priced at a premium to par with higher coupons and trade on a yield-to-call basis. The yields are more attractive since you are selling the call option back to the issuer. This allows you to move out on the yield curve with a little less interest rate risk.

Another area managers are looking at is in the single-name, short-term high-yield space with maturities of five years or less. One of main drivers here is the idea that many of the spread levels are still indicative of rates of possible defaults that now seem unlikely, especially considering their debt-distribution schedules.

For example, from a pure ratings standpoint, companies can receive junk status due to an abundance of long-term debt on their balance sheets. That can happen even when they have no trouble servicing their obligations from a near-term cash flow perspective. In addition, with some of the natural resources names in particular, recovery rates in the event of a default come into play since most have hard assets behind the company in the event of liquidation.

In the high-grade corporate space, financials are still trading wider than their nonfinancial counterparts, a theme consistent since 2007, but that clearly diverged to extreme levels in 2008-2009. This is still gradually reverting to the mean, as investors have been able to see a year's worth of earnings and feel more comfortable with their credit risk.

Putting Off A Day Of Reckoning

At the end of the day, the longer short-term rates are close to zero, the more it will burn a hole in investors' pockets.

Large institutions, including banks, insurance companies and pension funds, all have to invest new flows and existing bonds maturing somewhere almost regardless of their choice in yield.

This is how capital becomes misallocated and imbalances accumulate, but that's a topic for another day.

Chadd Bennett is a trader and former financial adviser specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

Don't forget to check IndexUniverse.com's ETF Data section.

Copyright ® 2010 Index Publications LLC . All Rights Reserved.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

In This Story

LQD EMB MUB MBB JNK HYG

Other Topics

ETFs

Latest Markets Videos