This is the final installment of three that contain a bond market analysis by money manager Strategy Asset Management, LLC.  (Installment I, Installment II)

Risk and Return

Bond investors will face some difficult choices in the months ahead.  Our base case for 2012 includes a modest acceleration of GDP growth accompanied by an improvement in employment and personal income.  US housing prices will finally stabilize and inflation, as measured by the Consumer Price Index less food and energy costs, will continue to rise.  (This inflation measure bottomed at 0.6% year over year in October and now stands at 2.2%.)  The Federal Reserve, however, is likely to keep short term interest rates at virtually zero.  All this points to a significant rise in government bond yields.

The current yield curve for government bonds looks strikingly similar to that which prevailed at the close of 2008.  Based on the improving domestic economy and our assumption that the European debt problems will be contained (admittedly, not a universally held point of view), we think the changes in bond market yields will be very similar to those which occurred in 2009.  If so, it implies interest rate increases in excess of 150 basis points for US Treasury securities with maturities of five years or more.  That translates into a near 12% price decline for ten year government securities.  To avoid these possible losses, investors would need to shrink the average maturity of their portfolios to two years or less and accept current returns of 0.25% versus the 2%-plus yields now available on longer dated investments.

Mortgages, normally a refuge for investors in a rising rate environment, pprobably won’t be a good port of call in 2012.  The market prices of high coupon mortgage securities are astronomical–GNMA pass-thru mortgages with coupons between 5% and 7% are being valued at 110% to 115% of par value.  These premiums are much higher than during previous low yield episodes; for example, GNMA 7% coupons never traded above 106 until mid 2010.  The current mortgage market bubble has occurred because mortgage refinance activity in these premium coupon mortgages has been exceptionally low, limiting prepayment losses for investors.  Borrowers have been unable to refinance because they are underwater on their existing mortgages and lack the equity to meet requirements on new mortgages.  That could all change with the stroke of a pen.

It is rumored that President Obama wants to replace the acting Federal Housing Finance Agency head with a more activist chairman and push for a multi-trillion dollar refinancing plan.  It would permit current borrowers in the government agency guaranteed programs to refinance into lower coupon mortgages with no requirements other than being current on the existing mortgage.  No appraisals, no income verification, no upfront payments.  This is actually a great idea.  It would save consumers tens of billions of dollars a year, increase housing demand and lift home prices, and boost economic growth–in an election year no less.  The losers under the plan would be holders of high coupon mortgage securities who would probably see the market value of their investments drop at least 5%.

While a change in the rules could hurt high coupon mortgages, their lower coupon cousins–the mortgage pass through securities with 3.5% to 4.5% coupons–would be crushed if interest rates rise.  Given the already inflated prices of even these securities, their upside appreciation potential, even in a declining interest rate environment is very limited.  (And we could see that further reduced if government actions unleash a flood of new low coupon securities.)  Meanwhile, they would suffer sizeable price declines and negative total returns if interest rates rise.

Making choices

As we begin 2012, most of our accounts are 20% to 30% below their benchmark maturity targets.  This is at the outer end of our usual duration bands and represents a significant call on the direction of interest rates.  During the fourth quarter of 2011, we added to our holdings of short term US Treasury notes.  We are generally overweight US Treasury securities compared with mortgages.  Nonetheless, a large rise in market yields would result in losses for most of our portfolios.  Accordingly, it is possible in the months ahead we may adopt an even more defensive maturity stance if the economic and political scenario we envision begins to materialize.

In closing, we thank you, our clients, for your support during 2011 and we will continue to work to merit your loyalty in the year ahead.  We wish you a healthy and prosperous New Year.

Note:  The Market Environment reflects the vies of the Investment Advisor only through the date of this report.  The Investment Advisor’s views are subject to change at any time based on market and other conditions.  December 31, 2011.

Thanks again to Strategy Asset Managers for allowing PSI to publish “Bond Market Environment, Fourth Quarter 2011.”