Boosting Bonds

With interest rate cuts likely,S&P recommends more exposure and longer term

By Palash R. Ghosh, S&P Global Editorial Operations - November 17, 2006

With interest rate cuts likely from the Fed in 2007, S&P is boosting the recommended exposure to bonds and going out longer term.

The Standard & Poor's Model ETF Portfolio has a new fixed-income allocation to reflect a decision by our Investment Policy Committee (IPC) to increase the bond portion of its overall asset allocation to 25% from 20%, while reducing the recommended cash exposure to 15% from 20%.

As a result, the Model ETF Portfolio's U.S. debt exposure, which is represented by the iShares Lehman Aggregate Bond Fund (AGG), will rise to 20% from 10%. The U.S. short-term debt component, the iShares Lehman 1-3 Year Treasury Bond Fund (SHY), will be reduced to 5% from 10%.

"In light of the weakening macroeconomic environment, we believe increasing the fixed-income allocation is prudent, with an emphasis on lengthening the average maturity and duration," says Alec Young, equity market strategist at S&P.

Similarly, the cash portion of the Model ETF Portfolio, represented by U.S. six-month Treasury bills, now accounts for 15% of assets.

The Model ETF Portfolio's exposure to equities remains unchanged: 40% U.S. stocks and 20% foreign issues.

The IPC says the increased bond exposure should serve as a hedge against weaker-than-expected U.S. economic growth and the probability that the Federal Reserve will begin easing short-term interest rates next year. S&P expects 2007 U.S. real GDP growth to slow down to 2.3% from the 3.4% forecast for 2006, primarily because of a cooling housing market.

The Federal Reserve has left interest rates unchanged at its last three consecutive meetings, after raising them 17 straight times since June 2004. The benchmark rate now stands at 5.25%.

Regarding the reduced cash allocation, Young says this reflects the likelihood that the Fed "is through tightening and will begin cutting rates by the second quarter of 2007. Hence, we believe cash yields have peaked and will soon be declining."

The Lehman Aggregate Bond Fund reflects the performance of the entire U.S. investment-grade bond market. Launched in September 2003, this exchange-traded fund has accumulated $4.44 billion in net assets and returned 5.3% for the 12 months ended November 8.

The ETF currently carries a weighted average maturity of seven years and an effective duration of 4.5 years. By comparison, the iShares Lehman 1-3 Year Treasury Bond fund has an average weighted maturity of 1.8 years and an effective duration of 1.7 years.

The iShares Lehman 1-3 Year Treasury Bond ETF, with $5.42 billion in net assets, was launched in July 2002. It seeks performance corresponding to the short-term sector of the U.S. Treasury market. For the 12 months ended November 8, it had a gain of 4.1%.

The Model ETF Portfolio gained 9.4% this year through the end of October.