What is the yield curve telling us?

by Wayne Ferbert on February 8th, 2012

Bill Gross, founder and co-CEO of PIMCO, writes an investment outlook every month and posts it on the PIMCO website. It is a very popular read for investment managers all over the world. Gross is considered one of the savviest fixed income investors EVER! He has guided PIMCO to its spot as the world’s largest fixed income asset manager – which is quite an accomplishment.

The Wall Street Journal highlighted Gross’ most recent outlook here – specifically his analysis of the flattening yield curve for Treasuries. Check out the blog-post on WSJ.com right here.

For Treasuries, Gross is pointing out three key points about the yield curve: (1) it is flattening; (2) it is remarkably close to zero on the short-end; (3) the outlook is for it to stay close to zero. Gross worries that there is no room for price appreciation in the Treasuries when they are so close to zero yield already. So, there is no incentive to reach out on the curve given the low yields and lack of difference in the yields along the curve. In fact, given significantly low yields and significant room for price DEPRECIATION, why buy these at all?

How does all of this affect the corporate fixed income market? Well, rates are, in part, pegged to the risk-free rate of return in the market. Treasuries are still the risk-free rate of return. So, the corporate fixed income market is similarly flattening – though not nearly as close to zero. But we recognize that even the corporate market has its own built in floor somewhere above zero. After all, corporate fixed income is not risk-free – so its floor is somewhere above the Treasury floor. It definitely looks like corporates have been approaching that invisible floor – and may already be there.

So, what does this mean for investing in and hedging your fixed income ETFs? I think it means that unless you are in retirement or approaching retirement, do not increase your fixed income exposure. Our book recommends that you replace fixed income in your allocation with hedged equity exposure. Stick to that approach. And if you already have fixed income ETFs with hedges, realize that the potential for price decline is real. The only saving grace is that the US Government doesn’t see itself increasing its rates any time soon – so the yield curve might stay this flat for a while leaving some room for side-ways price action for a few years.

On the other hand, Gross makes an interesting point: if this curve stays this flat and this low for too long, will the buyers show up to buy any fixed income or treasuries given all of the afore-mentioned risks – not to mention the credit risk?

All in all, fixed income ETFs are hard to swallow right now given the yield curve. The options market for puts for these fixed income ETFs reflects that risk. Hopefully, in the end, the equities market will continue to be the benefactor of the bearish outlook for fixed income. Investors will likely continue to move in to equities and keep this rally going – in fact, let’s face it, some of this rally can probably already be traced to the fixed income market outlook. None of us can guarantee that the market rally will continue – but given the fixed income market challenges, only one thing is certain: the bumpy ride will continue. When the ride is bumpy, consider hedging.

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EMHpe - May 4th, 2012 at 5:16 AM
A very well written article indeed. Although fixed income ETFs are a great source of a continuous source of income that every investors, but I think I will agree with gross here that given the conditions the yield curve is showing, it’s better not to take the risk for now.

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