Recent events in Cyprus coupled with higher valuations among lower-rated bonds illustrate that high-quality bonds can still play a role in investor portfolios.

A potential opportunity may exist among high-quality intermediate bonds following year-to-date strength in lower-rated bonds, the year-to-date rise in high-quality bond yields, and ongoing Fed policy.

The yield curve, a graphical representation of yields across the maturity spectrum of the bond market, has long received attention as a relatively good leading economic indicator. A flat or inverted yield curve has often predicted an economic slowdown or recession while a steep yield curve foreshadows economic growth.

However, the shape of the yield curve can impact total returns for bond investors and help determine which maturity segments – short, intermediate, or long-term - of the bond market offer the most attractive potential reward for a given amount of interest rate risk. The year-to-date rise in high-quality bond yields coupled with the current shape of the yield curve may offer investors an opportunity in high-quality bonds.

The yield differential between 2 and 10-year Treasury yields is one of the most common measures of whether the yield curve is “steep” or “flat”. The greater the yield differential between 2 and 10-year Treasury yields the “steeper” the yield curve, and conversely, the narrower the yield differential, the “flatter” the yield curve is considered. Currently, the yield curve is moderately steep based upon the yield differential between 2 and 10-year Treasury yields but well off a historically steep yield curve in recent years [Figure 1].

Federal Reserve (Fed) policy has greatly influenced the yield curve since late 2010 when the Fed extended the maturity of its bond purchases. Part of the Fed’s unconventional policy measures included putting a date around the timing of the first interest hike. In August 2011, the Fed committed to refrain from raising rates until mid-2013, then shifted to late 2014, and subsequently modified to mid-2015 before moving to its rough target of 6.5 percent unemployment (which also equates to roughly mid-2015 according to market expectations).

In mid-2011, the yield curve began to steepen notably at one-year but that inflection point has been pushed out to three years now due to Fed policy.  Although the yield differential between short and intermediate Treasures is less today, the three to ten-year maturity segment remains the steepest portion of the yield curve [Figure 2].

The Fed’s commitment to refrain from raising interest rates means there is much less interest rate risk for short-term and some intermediate-term maturity bonds compared to history. The year-to-date changes in Treasury yields reflect this phenomenon [Figure 3]. Treasury yields are higher year-to-date through yesterday, March 18, 2013, but the change primarily occurred in long-intermediate to long-term bonds. Thanks to Fed policy (and a sluggish economy), short-term one to three-year yields are essentially unchanged and the rise in bond yields is reflected almost entirely in longer-term issues. The change in the five-year Treasury yield is less than one-third of the ten-year. Short-term yields are likely to remain anchored due to Fed’s commitment and may benefit intermediate maturities. Historically, short-term yields responded more to changes to the likelihood of Fed interest rate hikes while longer-term bonds reacted more to changes in economic growth and inflation expectations. This remains the case, but especially so today, as Fed policy implies less interest rate risk and greater stability for short and short-intermediate bonds.

A potential opportunity may exist among high-quality intermediate bonds following year-to-date strength in lower-rated bonds, the rise in high-quality bond yields so far in 2013, and ongoing Fed policy. The primary benefit of a steep yield curve is the added compensation, in terms of yield, for every year an investor extends maturity. The steeper the yield curve, the greater the benefit to extend maturity.

However, a steep yield curve also offers defensive benefits. Over time, a bond will “roll down” the yield curve to a lower yielding maturity and this helps support bond prices. This concept is illustrated in Figure 4 for intermediate Treasuries. Over a one-year time horizon, if interest rates do not change, the total return of 5-year Treasury, 1.7 percent, exceeds its current yield to maturity of 0.8 percent as of March 18, 2013. On the surface, the total returns illustrated in an unchanged interest rate environment may not seem like much, but we believe they stand out in a low yield world. Such a holding could provide diversification benefits should the economy weaken or demand for high-quality bonds return. A slight decline in interest rates of 0.25 percent, in the event of safe haven buying, results in meaningfully positive returns. Of course, if interest rates by 0.5 percent, investors suffer a loss but again this may be an acceptable trade-off for an investor seeking diversification from high-yield bonds, for example, that have had a strong start to 2013.

The five-year Treasury yield has held in a very narrow range of 0.6 percent to 1.2 percent over the past 18-months thanks in large part to Fed policy. We view the prospects of a rise in interest rates of 0.5 percent, for five-year bonds, as unlikely given the Fed’s commitment to keep interest rates low. Therefore, high-quality intermediate bonds can provide a safety anchor for more conservative investors. While the 10-year Treasury also provides an attractive total return if interest rates remain unchanged, the potential loss if interest rates rise by 1.0 percent, on the high-end of our expected forecast, is risk we prefer to avoid. The 10-year Treasury yield has fluctuated in a greater 2.4 percent to 1.4 percent range over the past year and holds greater interest rate risk compared to four to seven-year bonds.

The analysis above exemplifies the defensive benefit a steep yield curve provides. The roll down strategy is used by many bond portfolio managers and a key reason why we continue to focus on intermediate maturity bonds.

Risks And Opportunities
The recently proposed rescue package for Cyprus is a reminder that ongoing European financial and economic weakness remain a risk for investors and highlights not only the need for a diversified portfolio but also the need to be tactical to take advantage of opportunities in the bond market. One of the brighter opportunities in the bond market for 2013, high-yield bonds, may be fading as the average yield of high-yield bonds declined to a new record low of 5.6 percent last week according to the Barclays index data. Demand may pause as record low yields may restrain additional buying. A prior decline in the average yield of high-yield bonds in January to then record lows was followed by a pullback in high yield bond prices. In a low yield world, bond investors have to look harder for investment opportunities and riding the yield curve may provide an opportunity in high-quality bonds.

Anthony Valeri has been with LPL Financial since June 1993. As Senior Vice President and Market Strategist, Valeri is a member of the Research department’s tactical asset allocation committee and is responsible for developing and articulating fixed income and general market strategy.