We continue to favor corporate bond sectors in fixed income portfolios and their greater yields as defense against rising interest rates.

However, we remain watchful of a signal from the Federal Reserve (Fed) that buying habits may change and warrant a reduction given now-higher valuations.

In our view, the end of bond purchases may not necessarily lead to a bond bear market.

Bond investors may revisit an early catalyst to bond market weakness in 2013, when Federal Reserve (Fed) policymakers reconvene this week. The official statement following the conclusion of this Wednesday’s Fed meeting will be scrutinized for clues about whether the Fed’s bond appetite may be satiated. Minutes of the December 2012 Fed meeting, released during the first week of January, sparked selling among high-quality bonds, as investors feared the Fed would end or curtail bond purchases earlier-than-expected. Minutes also revealed that…”Several others thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.” As we commented in early January, we believe bond market reaction to the Fed meeting minutes was overdone (please see the January 8, 2013, Bond Market Perspectives: Sour Start to New Year for more details), but scrutiny over the Fed’s bond holdings will continue.

With the Fed’s balance sheet surpassing $3 trillion [Figure 1], investors’ attention may once again be drawn to the Fed’s bond buying. The Fed is widely expected to maintain its current bond-buying diet of $45 billion in long-term Treasuries and $40 billion of government-agency mortgage-backed securities (MBS) as Fed policymakers reconvene this week.

Figure 1: Federal Reserve Bond Holdings

However, in 2013, the Fed is no longer offsetting Treasury purchases with Treasury sales. The Fed will be buying a total of approximately $115 billion of government bonds per month after including reinvestment flows, which have averaged slightly more than $30 billion per month over the last six months. At that rate, the Fed’s balance sheet will be steadily progressing toward $4 trillion, and bond investors are assessing the potential impact.

Fed Buying and Bond Valuations
Fed bond purchases, and subsequent expansion of the balance sheet, are one of the main drivers of expensive bond valuations. As the Fed’s balance sheet has grown with bond holdings, the yield on Treasury Inflation Protected Securities (TIPS) fell and, until recently, declined further into negative territory [Figure 2]. Fed bond purchases, in addition to the Fed’s commitment to refrain from raising interest rates for an extended period, have certainly contributed to making Treasury bonds expensive.

Figure 2: Fed Bond Purchases, as Reflected by a Growing Balance Sheet, Have Led to Higher Bond Valuations and Lower Yields