Up the Long Bond Ladder

04/01/2011 9:41 am EST

Focus: BONDS

Joe Battipaglia

Market Strategist-Private Client Group, Stifel Nicolaus

Bonds have an uncertain future, but there's one way to protect yourself from a bond downturn while squeezing a couple of extra points out of your fixed income, says Joe Battipaglia of Stifel Nicolaus in this exclusive interview with MoneyShow.com.

Joe, obviously a lot of investors have flocked to bonds over the last couple of years, but we’ve seen a couple of big sell-offs in the bond market recently. What do you see going forward for bonds?

Well, in the short term there’s a concern that inflation is going to break out, requiring higher yields. Because of government spending, they need an ever-greater quantity of bonds placed, so the market is having to accept greater volume—but I see a big battle breaking out here between the forces of deflation and inflation.

Interesting.

I’m not sure who’s going to win this one.

So, deflation is still—I mean people have said deflation is kind of last year’s problem.

Well, you would think so.

You think it’s still alive and well, the threat of it?

Well, I disagree with Ben Bernanke’s policy on steering the monetary base.

He is worried about this deflation issue, which is to say that credit destruction is happening faster than credit creation, and has negative implications for economic growth, economic performance, and the foundation of the banking system, so he’s pushing against that with the quantitative easing.

In the real world, inflation rates are jumping all over the place as it relates to commodities and the day-to-day cost of things, but where I look is financial inflation: What kind of balance do we have in the financial system? And we still have some serious deflationary pressure.

Such as?

Well, the fact that credit demand is coming back ever so slowly, but it’s a peg below where it had been before. And two, in some major sectors of the economy—particularly housing—the leverage factor is crushing the valuations there, and it’s hurting the economy.

So, its things like that that are of concern to me, and then of course the sovereign-debt crisis in Europe hasn’t totally abated, it’s just moved from place to place—and they’re trying to put as many fingers in the dyke as they can.

So this battle royale between deflation and inflation is going to continue to play out. For us, what we do is we do a ten-year ladder, because we can’t say for sure where you’re going to be five or ten years from now.

This way, every five years the portfolio turns over 50%. If you’ve got good bonds, they’ll stay close to par as you get near the maturity date, and that’s how you immunize yourself while getting the defensive value of owning bonds.

So, for the average, let’s say people who are investing for themselves and trying to decide they’re in bond funds, what kind of things do you recommend for them?

Well, I like the investment-grade corporate category, where the managers are staying on top of the credit quality of the issuer.

What duration, or maturity? Intermediate?

Well, as I said, I want to ladder it, so I literally want to have 10% coming due each year for ten years. So that in five years time, half of it is turned over and I’m reinvesting at the then-new interest rate, so if I’m wrong and rates go materially higher, you move with them.

In this manner then, you don’t have the problem you had in the '70s where inflation ravaged the bond portfolios, and at the same time you can get reasonably good yields—maybe 150 to 175 basis points better than the current five-year rate on the Treasury, so that you have some positive attributes to your bond investments today.

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