How to Navigate the Bond Market

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

According to a recent report by the Federal Reserve, household debt in the U.S has declined to its 2006 levels. This drastic reduction was a direct impact of the Fed’s liquidity injections, which have resulted in a declining unemployment rate and rising consumer spending. This is great news for the banking industry, as debt repayments have lowered the risk of defaults and unlocked liquidity for reinvestment purposes.

Why Wells Fargo?

One of the best ways to play this recovery is by investing in Wells Fargo (NYSE: WFC). It is by far the largest mortgage originator in the U.S, with a 22% market share, and it originated $524 billion worth of home loans in FY12. However, the best thing about the bank is that it has over $160 billion in cash and cash-like instruments due to rapidly growing deposits.

Normally, idle cash and cash equivalents points towards a poor reinvestment mechanism in a company. This is because its ROE and ROI ratios are dampened by inaction. But in a recent press release, the management of Wells Fargo announced that it is buying bonds at a relatively faster rate.


The above chart displays the trends of 10-year Treasury bonds. The benchmark 10-year Treasury yield started rising, shortly after the Fed announced that it might terminate the monthly QE3 stimulus sooner than expected. The market got spooked due to weak investors confidence, following which money started flowing out of bonds.

The bank stated that it has created a portfolio of certain instruments, which altogether profit the bank if interest rates start to rise. Theoretically speaking, if Wells Fargo invests its entire liquid cash into 10-year bonds at the current yield of 2.52%, it will be looking at $3.84 billion in annual interest income. That will boost its annual net income by around 20%, which is why Wells Fargo presents a bullish case.

But that’s just theoretical, and the bullish bond market is feared to have come to an end.

Why Is the Street Worried?

Bank of America (NYSE: BAC) is particularly bearish on the bond market and advised investors to close their positions in bonds, while they still have a chance. The bank stated that the termination of Fed’s easing will leave a gaping hole on the buying side, due to which bond yields can continue to soar. And since major banks will now start selling bonds, there’s a good chance that bond yield becomes volatile and trap long-term investors. As of now, Bank of America has bearish bets on treasuries and stands to gain $1.6 billion if interest rates rise by 1%.

Meanwhile JPMorgan Chase (NYSE: JPM) also has bearish bets. According to an annual newsletter to shareholders, CEO Jamie Dimon revealed the magnitude of the bank’s bond bet. He stated that if treasury rates sharply rose by 3%, the bank will stand to gain around $5 billion in the coming 12 months. The bank is also bearish on the Asian bond market and suggests that a cut in the Fed’s stimulus package will lead to investors dumping their bonds in developing nations.

However JPMorgan continues to be a risky play and has recently been downgraded by several ratings agencies and research firms. So the question arises:

Are the Guys at Wells Fargo Crazy?

According to the Chief Fixed Income Strategist at Wells Fargo,

“We are now hearing that this is the onset of the dreaded bear market in bonds, but the truth is probably less exciting. The Treasury market, which was overbought, has adjusted to be more consistent with an economy that is growing—albeit slowly—and the absence of a crisis overseas. At the current higher yields, Treasuries have become more attractive versus German and Japanese government notes and bonds, so foreign demand might improve somewhat. I do not expect this market correction to push the 10-year yield beyond 2.25%.”

The above explanation sounds clear and realistic. I honestly don’t think that the Fed will destroy the bond market. The bond market seems to be spooked right now and will most likely rebound from the Fed’s shocker. But I also do not recommend investors to directly invest in treasuries, as they can turn volatile. However, investing in Wells Fargo would be a great strategy to both limit exposure to bonds and enjoy the benefits of rising interest rates in the future.

 

Many investors are scared about investing in big banking stocks after the crash, but the sector has one notable stand out. In a sea of mismanaged and dangerous peers, it stands out as The Only Big Bank Built To Last. You can uncover the top pick that Warren Buffett loves in The Motley Fool's new report. It's free, so click here to access it now.


Piyush Arora has no position in any stocks mentioned. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, JPMorgan Chase & Co., and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure