Ready, Fire, Aim
The fact that financial markets are closing the first half of 2013 on such a volatile note is not so surprising given the concern investors have about the timing of the Federal Reserve’s contemplated exit from quantitative easing. The Fed has been instrumental in manufacturing a rebound in housing that is adding not only to the investment accounts of the GDP equation, but also indirectly to consumer spending through the wealth effect of higher home prices and 401(k) values. Against this backdrop, several Fed governors and regional bank presidents hit the lecture circuit this week to clarify for investors that the Fed is not imminently planning to reduce monetary accommodation. Stocks responded in predictable fashion, and are now set to post the best first half gains since 1999, with returns of about 14 percent. We continue to believe that the Fed will remain accommodative for some time to come, helping support further expansion in a U.S. economy that many Americans still think is in recession.
Bonds . . . Et Tu Brute?
In the bond market, it’s another story entirely. Although benchmark 10-year Treasuries stabilized this week, bond indices are littered with small losses for the first half of the year. The good news is that bond investors who put money to work today are realizing real rates of return for the first time since early 2011. For example, a benchmark Treasury purchased today yields a nominal 2.5 percent which, when a 1.4 percent rate of inflation is subtracted, results in a real rate of return equaling 1.1 percent.
With the recent spike in interest rates, we encourage clients to recognize the power of time and reinvestment to heal bond market wounds. In addition, we would note that recent bond market “losses” will only be realized if investors sell their paper below par. To that end, we plan to continue owning our clients’ bonds into maturity and look forward to reinvesting those funds at higher rates of interest. Furthermore, fixed income investors can reduce interest rate risk by structuring bond portfolios with shorter term maturities, thus reducing the duration of their investments and hastening the maturity of lower coupon bonds. On the other hand, investors in bond funds confront a harsher reality. In a rising interest rate environment, the net asset value of these funds drops with bond prices, but unlike a portfolio of individual bonds, there is no assurance that their initial purchase price will be recouped because they share ownership of that fund with other investors. Indeed, what we are beginning to see now is an accelerated rate of bond fund redemptions by investors who don’t want to wait for bonds to mature. In this case, losses may be realized by fund managers forced to sell, with proceeds used to redeem the bond fund shares being liquidated.
As the second quarter of 2013 comes to a close, we wish our Ferguson Wellman friends and clients a happy and safe Fourth of July holiday. Investors should rest up, because second quarter earnings reports are right around the corner!
Our Takeaway from the Week
- Stock and bond markets stabilized following reassuring comments from Fed officials and generally upbeat economic data