Sticking With Two Bond Winners

09/02/2010 12:00 pm EST

Focus: BONDS

Yiannis Mostrous

Editor, The Capitalist Times

Yiannis G. Mostrous, editor of Silk Road Investor and Emerging Markets Speculator, says he still likes medium-term Treasuries and emerging-market sovereign debt.

Back in March, we identified iShares Barclays 3-7 Year Treasury Bond (NYSEArca: IEI) as one hedge that has a place in any well-diversified portfolio.

Although our recommendation came a bit early, the yield on the benchmark ten-year note peaked at 4.01% on April 5th and since then has plunged nearly 120 basis points. Such moves are commonly regarded as a prelude to recession; we would argue that moves in the bond market alone aren’t a reliable indicator of economic trends, especially when the role of nonmarket entities in the economy is extremely high.

That being said, our case for Treasuries isn’t based on the potential collapse of the US economy; rather, we believe economic growth will decelerate and that inflation won’t rear its head for at least another year. US households remain in debt-repayment mode, and as long as wage growth remains subdued, deflationary pressures will rule the day.

US gross domestic product (GDP) grew 2.4% in the second quarter, prompting many economists to lower their estimates of full-year US economic growth to less than 2%. Although downside risks have increased, we maintain that the US economy should beat these pessimistic forecasts.

The current recovery is unquestionably weak relative to previous rebounds, and a host of uncertainties threatens to constrain economic growth. For example, consumer spending, household incomes, and employment growth remain weak, prompting many investors to stay on the sidelines.

But the Federal Reserve will do anything in its power to achieve respectable economic growth; don’t expect Ben Bernanke and his cohorts to raise rates dramatically over the next 12 months. But they do have the ability and the power to make effective policy.

Inflation is a danger over the long term—one of the reasons we prefer shorter-duration bonds.

We’ve recommended iShares JP Morgan USD Emerging Market Bond (NYSEArca: EMB) since mid-April. The exchange traded fund (ETF) invests primarily in sovereign debt, though debt issued by national energy companies and other quasi-sovereign entities accounts for roughly 15% of the portfolio. The ETF has returned almost 10% since our recommendation; including dividends, this comes out to a 25% annualized return.

When we added the fund, we noted that issues from the Russian Federation accounted for 9% of its investable assets. At the time, these holdings were undervalued. Russia is a country investors love to hate, so it’s no surprise that its debt is usually discounted on the assumption that there’s substantial political and default risk. Of course, neither assumption is valid.

Although Russia’s relationships with its neighbors can be tempestuous, it’s the largest trading partner of most the countries in the region. And the country has gotten its fiscal house in order since the Russian debt crisis.

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