This summer saw mounting bad news for the economy. The job market is at a standstill, the housing market continues to search for a bottom, and median household income and net worth fell. With the market limping forward economist’s put the chance of the U.S. falling back into recession at 1 in 3. Amongst this bleak economic backdrop the Fed held an extended meeting to try to find a course of action that could help lift the economy from the doldrums. They decided on “Operation Twist” a new stimulus program whereby it will reposition its bond portfolio to be longer term and it will reinvest proceeds from maturing mortgage backed securities back in to additional mortgage backed securities. The Fed plans to buy $400 billion of longer term Treasurys by June of 2012 to reduce long term interest rates and sell short term Treasurys to cover the purchase. The program is designed to spur growth in the economy through increased spending and investment and aid the sluggish housing industry.
What does this new Fed policy mean for your portfolio? The purchase of longer term Treasury bonds should drive up their prices. The Vanguard Total Bond Market fund and the iShares Intermediate Term/Government Credit Bond fund both have exposure to longer term treasury bonds, which should benefit from the move. The funds have a 52% and 22% allocation to longer term debt, respectively. The Fed will be selling short term Treasury bills to make the purchases, which should drive down their value to some degree. However, losses from these holdings should be muted as the securities are short term and high quality and thus do not see large moves up or down from selling/buying pressure. In addition, the current unease in the economy has kept short term government debt in high demand, which will help buoy their market value. The Vanguard Short Term Federal fund would be affected by the Fed’s selling of short term debt. However, the Fed will also begin reinvesting its maturing mortgage backed securities positions into new mortgage backed securities and the Vanguard Short Term Federal fund as well as the Vanguard Total Bond Market fund have exposures to these investments and should benefit. The Vanguard Short Term fund has an approximate 25% allocation, while the Vanguard Total Bond Market has close to 31% in mortgages.
On the whole, fixed income portfolios with exposure to both long term debt and mortgages should benefit from the Feds latest moves. While certain maturities and sectors may have better performance in the near term, it remains important to be well diversified in the fixed income portion of a portfolio. Maintaining exposure to government, corporate, mortgage and international debt as well as short, intermediate, and long term maturities reduces the risk that a future fed move or change in the markets can catch your portfolio off guard.
Index Performance September Third Quarter YTD
US Large Cap Stock (Russell 3000) -7.76% -15.28% -9.90%
International Stock (FTSE AW ex US) -11.28% -20.01% -16.62%
US Broad Bonds (BarCap Aggregate) +0.73% +3.82% +6.65%
US Short Term Bonds (BarCap Gov 1-5 Yr) -0.13% +1.29% +2.78%
Municipal Bond (BarCap 1-10yr Muni) +0.14% +2.38% +5.69%
Cash (ML 3Month T-Bill) +0.00% +0.02% +0.10%
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