Posted by Sean Hannon 7 August 2009

Lowering Bond ETF Exposure, EPIC Insights Update

While stock trades rely on absolute value, bond market trades rely upon relative value. Two factors affect the value of a bond:

  1. Interest rates. Rising rates push prices lower, and falling rates drive prices higher.
  2. The risk spread needed to compensate an investor. Those who buy Treasury certificates require very little risk premium, while those purchasing bonds of speculative companies require enormous risk premiums.

Currently as highlighted in my weekly newsletter EPIC Insights, we own three positions which track various sectors of the bond market. They are the Eaton Vance Senior Income Trust (EVF) as a proxy for bank loans, iShares Investment Grade Corporate Bonds (LQD) as a proxy for investment grade companies, and iShares High Yield Corporate Bonds (HYG) as a proxy for junk bonds.

When we purchased these positions, risk was a four-letter word. Investors had rushed into government bonds and pushed the spreads on these risky instruments to levels not seen in many years. Recognizing the opportunity, we allocated 10% of our portfolio to these trades. When the spreads narrowed, we were rewarded. On a price basis, these three instruments have returned 24%. If you factor in the interest income earned during the holding period, the total return is even higher.

Bonds Outlook

As I often state, reflecting on past gains is satisfying, but we earn our money on what happens tomorrow. As investors have become more comfortable with risk, spreads have tightened. At today’s prices, we see credit spreads where they traded before the Lehman Brother’s bankruptcy. Considering this, we must now attempt to gauge the direction prices will travel and what further upside remains.

Revisiting the two factors that drive price changes, interest rates and credit spreads, I am bearish on both. While the Federal Reserve has allowed massive liquidity to support the market, we must expect it to eventually trigger inflation and rising interest rates. With credit spreads tight, there is a greater likelihood that they will widen instead of contract further. Widening spreads and rising rates would act as a two-pronged attack on our portfolio and I see no reason to relinquish gains. While I still wish to maintain bond positions for current income and diversification needs, we do not need them to consume 10% of our portfolio. Instead, we will scale back and look for future opportunities. I recommend selling 50% of the positions in EVF, LQD, and HYG as this week’s fundamental trade.

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