Bonds, Bernanke, and Beyond

The bond market is headed into uncharted waters. An 18-month period of gradual interest rate increases is drawing to a close, and a new chairman, Ben Bernanke, has just taken the reins of the U.S. Federal Reserve Board, the most influential economic body in the world.

What does this mean for bond prices? And how are professional investors anticipating these changes? We asked Wan-Chong Kung, who manages roughly $62 million in the Intermediate Government Bond Fund, part of Minneapolis-based U.S. Bancorp’s First American Fund family.

{Q} Markets don’t like uncertainty. Do you think the market is at all nervous about the transition to a new Federal Reserve chairman?

{A} I don’t believe so, judging by how tight the price differences are between low-risk treasury bonds and higher-risk corporate bonds. The yield curve is essentially flat. Risk assets are expensive. There doesn’t seem to be much cushion for unforeseen events.

{Q} So you’re not getting paid for taking more risk, is that correct?

{A} That’s our view. There certainly have been good reasons for the current low risk premiums. One is the remarkable transparency of the Fed and its very gradualist process of raising rates. Another reason is the moderation of the business cycle—GDP growth has been very steady, averaging about 3.5 percent. Inflation volatility is very low, with the exception of the post-Katrina energy spike. So this economic environment has provided very few surprises for investors, and given investors the ability to buy longer-maturity bonds, which have higher yields, and lower-credit-quality bonds, which also yield more.

This is what has tightened those price differences, or the so-called risk premium, in the bond market. But looking ahead to ’06, it seems fair to expect some widening of the risk premium.

{Q} Aren’t there other places that could provide a better return to fixed-income investors?

{A} On a global basis, the U.S. is one of the higher yielding markets, and supply here has been low. The 30-year Treasury was discontinued in 2001; corporations have been sitting on a lot of cash and have not been tapping the bond market for money. Issuers such as Fannie Mae and Freddie Mac—the nation’s two biggest pools of mortgages—have been in retrenchment mode, fixing their internal accounting issues and not growing their retained portfolios. Even mortgage supply has been low, as origination has been diverted to adjustable rate mortgage products.

{Q} What has happened to demand?

{A} Globally, we’ve seen very high liquidity—foreign central banks needing to invest dollars. We’ve also had the issue of the gap in pension funding, and that has been a source of demand for the market.

{Q} There’s been some speculation that the Fed in ’06 may, in fact, become less transparent. Do you anticipate this possibility, and how could it affect the bond market?

{A} I think the Fed’s current policy of telegraphing policy actions is very well entrenched. It’s been a great success for the Fed, and I don’t think it will get reversed, even with a new Fed chairman. In fact, I think Ben Bernanke is an even stronger advocate than Greenspan for that kind of transparency. Having said that, while I think the desire to be communicative is very much there, we are at the point in the tightening cycle where the ability to do so may not be there. As the Fed gets closer to the end of raising rates, it becomes more difficult for them to provide the market guidance. It becomes more difficult for the Fed to anticipate the economy’s reaction.