When the 10-year Treasury Bond spiked from 3.11 percent to 4.375 percent over a six-week span, it unfortunately sparked the bond sell-off heard around the world. Placid fixed-income investors nervously focused on the plummeting value of their portfolios, and not on the reasons why they invested in bonds in the first place: the relative safety from the short-term ravages of fickle equities markets. The sudden, violent rise in rates took everyone by surprise, and oversupply quickly dwarfed dwindling demand.

Return To Near Normalcy

The good news is now that the efficiency of the bond market has scared away the hiccups, things have stabilized. Institutional portfolio managers and individual investors alike have caught their collective breaths. And after the dust settled, bond yields still were hovering at or near 45-year lows.

Issuers, Underwriters, Distributors and Investors Make the Fixed Income Game Efficient

Corporations still need to manage cash flow, and finance operations and capital improvements. State and local governments, schools, and the health care industry continue to borrow at a record pace.

Investment bankers are advising their corporate clients to manage interest rate risk using a variety of hedging strategies, such as interest rate swaps, caps, floors and collars. This helps companies match their debt service flows with their outlook on rates, and improve management of their balance sheet, as well as gives them access to alternate interest rate structures.

For the investor, bonds continue to inhabit their accustomed place in a diversified portfolio, providing stability and income. True, if the economy recovers and rates rise over the next few years, today’s investment grade bonds are overvalued. Consider this, however: investors include bonds in their portfolio to guard against exactly what has happened over the last three years — a weakened economy and an uncertain equities market. So what is the difference now? Investors are realizing it may be just as important to diversify among their fixed income portfolio as it is with equities.

Scandals Erode Investor Confidence

According to Susan Janson, Managing Director, Investment Banking Group, Comerica Securities, many underwriters, including herself, believe that scandal-ridden big corporate America has actually had more to do with decreased demand in the fixed income market than the specter of rising interest rates.

"The impact of corporate accounting scandals has had a greater impact on yield and price than issuance " said Janson, referring to the recent cascade of high-profile accounting scandals. "That said, demand still continues to be there. We've seen only a slight pullback even as investors, just entering the market now, are demanding higher yields."

Build with Ladders, Insulate with Savings Bonds

So, where should investors go with their fixed-income allocation? Staggering or laddering maturities every one or two years over the life of an investor’s portfolio has become one proven way to control interest rate risk. Janson believes that current ladder purchases which include maturities in the two- to five-year range can be used to pick up yield over today's short term rates, but generally the wisdom of laddering lies in establishing continual maturities to hedge spikes or valleys in the interest rate environment.

Try a Little Junk?

Some experts also like high-yield corporate bonds, especially if the economy continues to show signs of a true recovery. These "junk bonds" are paying 8 percent or higher, but carry with them a proportionally high degree of risk. For sophisticated investors with well-diversified portfolios, these types of securities may make some sense.

Oversupply Makes Some Munis Attractive

With supply outpacing demand, the municipal bond market is offering relatively high yields these days. One look at 2003 shows that this year's issuance is likely to exceed 2002's record numbers, according to some analysts.

The marvel of the efficient market is that although certain states may experience extreme credit pressures, the market recognizes the ongoing need of those states and their municipalities to continue to borrow. The result is continued demand at a price.

“When we look at underwriting a municipal bond, we consider the entire package to determine whether our customers have an appetite for certain credit exposures and at what yield,” said Janson. Municipal buyers tend to be conservative investors.

“Consider the overall strength of the municipal market”, said Janson. “Municipal GOs are second in quality only to U.S. governments."

What about the Great Rate Spike of 2003?

Janson dismisses the "bond trouble" hype. "What happened was a logical repositioning after the market found itself in an overbought position, not a mass withdrawal,” she explained. “The demand is still there, especially with conservative investors."

This article appeared in Crain's Detroit Business, August 2003. (CO)

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the ManzellaReport.com, is a world-recognized speaker, author and an international columnist on global business, trade policy, labor, and economic trends. His latest book is Global America: Understanding Global and Economic Trends and How To Ensure Competitiveness.

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