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Sometimes it’s not just an interest rate hike that moves markets, but what Federal Reserve Chairman Alan Greenspan says afterward.
On June 30, the policy-setting Federal Open Market Committee, as expected, raised its target on the federal funds rate-what banks charge each other for overnight loans-0.25%, to 5% from 4.75%. Of greater significance to bond professionals, however, was the Fed’s change in bias-or the direction of its interest-rate policy-from “tightening” to “neutral,” which it announced that same day. Some think this means there’s less of a chance the Fed will immediately raise rates.
“The Fed’s decision to raise interest rates 25 basis points was a good decision. But more important was the change in bias to neutral from tightening,” says Mark D. Lay, chairman and CEO of MDL Capital Management in Pittsburgh. Although the yield on the long bond could jump to as high as 6.25%, Lay believes it will dip down to 5.25% by the end of the year. The reason? “There’s absolutely no inflation in this economy and no signs of inflation in this economy,” he says.
“This is a market driven by the Fed’s activity,” says Napoleon Rodgers, managing director at Alpha Capital Management in Detroit. Rodgers, who manages $75 million in bonds, thinks the central bank has “provided themselves a cover” by moving to a neutral bias. He adds that due to fears of a Fed tightening, the long bond’s yield could stay in a trading range between 6.35% and 5.75% for the rest of the year.
Given this volatility, he’s moved into the shorter end of the yield curve, purchasing investment-grade corporate bonds maturing in two to five years, rated double A or higher. At the same time, he’s trimmed his holdings of longer-dated Treasuries and has purchased federally issued mortgage-backed securities from the Federal National Mortgage Association, for example.
His advice to retail investors who want to purchase individual bonds is create a “laddered portfolio,” with bonds maturing in four and a half years or less, in order to protect themselves in this uncertain rate environment. Rodgers adds that mom-and-pop investors should stay away from lower-rated corporate bonds and purchase securities issued by solid blue-chip companies such as AT&T (NYSE: T) and Ford Motor Co. (NYSE: F).
But while Lay agrees corporate bonds backed by well-known firms can be a good value, he’s shying away from the corporate sector. He thinks spreads-the difference in yield between corporates and Treasuries-will continue to widen. Lay would like to see the spread reach 80 to 120 basis points over 10-year Treasuries before he wades in again (a basis point equals one one-hundredth of a percent). Lay has just 2% of his core portfolio in corporates, with 5% in asset-backed securities, 12% in mortgage-backed securities and the rest in Treasuries.
“Because of the backup in rates, I would encourage retail investors to buy longer-dated rather than shorter-dated securities,” the opposite of Rodgers’ advice, Lay says. Specifically, individual investors should build a laddered portfolio with longer maturities of 10 and 30 years composed of current