Tag Archives: high yield

Fixed Income Review – July 2019

We delayed publishing the July Fixed Income Review so we can present fresh data and comment on the surge in volatility following the Fed meeting (7/31) and new tariffs on China (8/1). 

In general, the fixed income markets were mostly sleep-walking through July in anticipation of a July 31st Federal Reserve rate cut and a much-anticipated dovish statement from the Fed.  As if on autopilot, stock markets slogged higher and credit spreads moved tighter throughout the month. Meanwhile, Treasury yields rose modestly after their dramatic declines in May and June. Indeed, as the table below reflects, Treasuries were the only major fixed-income class to lose ground on a total return basis in July. All other categories posted positive returns for the month.

In stark contrast, the ETF table below highlights some of the significant changes we have seen since the beginning of August.

Following the Federal Open Market Committee (FOMC) meeting on July 31 and the subsequent press conference delivered by Chairman Jerome Powell, the future of monetary policy was suddenly in question. For the first time in several months, the Fed failed to deliver a dovish surprise.

Part of Powell’s response to the first question in the press conference regarding the “hurdle” for further rate cuts was as follows:

“…the committee is really thinking of this as a way of adjusting policy to a somewhat more accommodative stance to further the three objectives that I mentioned. To ensure against downside risks, to provide support to the economy that those factors are pushing down on economic growth and then to support inflation. So, we do think it’ll serve all of those goals. But again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

Despite the evidence and assurances of rate cuts to provide a firebreak against any potential weakening of the economy, Powell’s reference to “a midcycle adjustment” suddenly raised doubts about their conviction for further easing.  

Given the strength of the U.S. economy, the “downside risks” he refers to are clearly emanating from foreign sources. Now add a Fed that may not be ready to cut rates further and the renewed escalation of the trade war between the U.S. and China and one has a potent cocktail for the volatility seen since the end of July.

As can be seen in the tables above, fixed-income markets in July were mostly a non-event but the first several days of August have been full of fireworks. The table below illustrates the move in U.S. Treasury yields since July 31.

Investment grade and high yield markets reacted with some displeasure to Jerome Powell’s comments and new rhetoric from the administration on trade and tariff challenges associated with China. Although the magnitude of the spread changes did not breach any meaningful technical levels, the speed of the change was rather head-snapping.

We end up in a familiar place. If we are to take the Chairman at his word and potential downside risks warrant a rate cut, it becomes even more challenging to justify the valuations investors are being asked to pay to own risky assets. Despite having posted new highs in recent weeks, the S&P 500 has produced a 3.48% annualized total return over the past 18 months along with volatility of 15.5%. High yield bonds have delivered annualized total returns of 4.80% with 12.9% volatility. Net out the most recent inflation data of 1.6% from those numbers and we struggle to understand why investors have been so enthusiastic.

Eighteen months ago, one could buy 10-year Treasuries at a 2.85% yield. The 7-10 year ETF (Ticker: IEF) has delivered 3.55% total return and with only 4.4% volatility. Needless to say, while not glamorous, the risk-free route provided returns on par with stocks and high-yield but with significantly less volatility. Given the risks Chairman Powell has outlined, might Treasuries, despite near-record low yields, be the safe place to hide in fixed income for the time being? Astute, rational investors will either figure that out on their own or the market will impose its will.

All Data Courtesy Barclays

Fixed Income Review – June 2019

As central banks have become collectively more dovish throughout 2019, monetary stimulus appears to be back in control of the economic cycle. The Federal Reserve ratcheted up their easing posture at the June Federal Open Market Committee (FOMC) meeting as one voting member dissented from the group in favor of a rate cut. There were other non-voting members even arguing for a 50 basis point rate cut on concerns about the economic outlook and still muted inflation pressures. Keep in mind this abrupt flip in policy is coming despite unemployment at near half-century lows and inflation hovering around 2.0%, the supposed Fed target.

With that backdrop in play, it is no surprise that June was a good month for all risk assets. Within the Fixed income arena, the riskiest of bonds outperformed against the spectrum of safer fixed-income products. As the table below highlights, every major category performed well with emerging markets (EM) leading the way and investment grade (IG) and high yield (HY) corporate returns close behind.

Fixed income has now completed a “round trip” from June 2018 as yields and spreads in almost every category are back below the levels observed at the same time last year. The tables below illustrate those moves in both yields and spreads.

The anticipation of what is being called “insurance rate cuts” from the Fed as well as easing measures expected from the European Central Bank (ECB), offered investors comfort that these potential actions will keep downside risk and volatility at bay. The hope is that the central bankers are sufficiently ahead of the curve in combating weaker global growth.

Despite investor optimism about the outlook as evidenced in the first half performance, risks remain. Most notably, ongoing deceleration in trade and industrial activity could worsen and bring an end to the current record-long economic U.S. expansion. The United States is surrounded by economies that are faltering, including Canada, Australia, Europe, Japan, much of southeast Asia and, most importantly, China. The Trump trade policy agenda only adds to these risks, especially for those countries dependent on exports for economic growth.

If risks do not abate, then we should expect forceful actions from central bankers. The common response of Treasury yields and the yield curve is for the short end (out to two- or three-year maturities) to drop significantly and the long end to either hold steady or fall but much less so than short rates resulting in what is called a bullish curve steepener. As we discussed in Yesterday’s Perfect Recession Warning May Be Failing You, past episodes of rate cuts illustrate this effect.

With investors complacent, yields and spreads on risky assets back to extremely rich levels, and global trouble brewing, the pleasant by-product of recent Fed rhetoric might quickly be disrupted. If so, the gains of the first half of 2019 would become a vague memory.

Apart from slowing global trade and industrial activity, keep in mind there are plenty of other potentially disruptive issues at hand including China leverage, Brexit, the contentious circumstances between the U.S. and Iran, the Italian government fighting with the European Commission on fiscal issues, Turkish currency depreciation, on-going problems in Argentina and more.

At the moment, the Fed and the ECB appear to have the upper hand on the markets, and higher yielding asset alternatives that reward an investor for taking risk are benefiting. Still, a critical assessment of the current landscape demands that investors engage and think critically about the risk-reward trade-off under current circumstances. The Fed and the ECB are not hyper-cautious and dovish for no reason at all. There is more to the current economic dynamic than meets the passive observer’s eye.

All Data Courtesy Barclays

Fixed Income Review – May 2019

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Goldman Sachs on Corporate Debt: Myopic or Self-Serving?

The biggest problem that most people have is that they read Wall Street research reports and they believe the Wall Street hype… Wall Street analysts are very, very easy to fool, they’re generally parrots for what management tells them.” – Sam Antar, former CFO Crazy Eddie

In 2018, Goldman Sachs underwrote 513 corporate debt issuance deals totaling $94.5 billion. They were paid an average fee of 0.48% or approximately $453.6 million for those efforts.

In a recent research report entitled, Corporate Debt Is Not Too High, Goldman Sachs discusses why they are not concerned with the current levels of corporate debt despite record levels of corporate debt when compared to the nation’s GDP as shown in the chart below.

Goldman’s argument cites the following four reasons:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets
  2. Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period
  3. Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk
  4. The corporate sector runs a financial surplus which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

As discussed in our article The Corporate Maginot Line, not only have corporate debt levels risen dramatically since the financial crisis, but the quality of that debt has declined markedly. With the post-crisis recovery and expansion, the full credit spectrum of corporate debt levels are significantly larger, but debt outstanding in the single-A (A) and triple-B (BBB) rating sectors have grown the most by far.

Unlike previous periods, the composition of corporate debt within the investment grade sector is now heavily skewed toward the riskiest rating category of BBB. BBB-rated securities now represent over 40% of all corporate bonds outstanding. Additionally, all sorts of other risky loans reside as liabilities on corporate balance sheets and are potentially toxic assets for banks and investors. Most notable are leveraged loans extended to businesses by banks to corporations.

Beyond the amount of debt outstanding, another consideration related to creditworthiness are the uses of cash raised by corporations via debt issuance. Have the proceeds been used productively to enhance the future earnings and cash flows of the company, thereby making it easier to service the debt, or have they been used unproductively, creating a financial burden on the company in the future?

In A Perfect World

In an environment where the economy continues to grow at 2% and interest rates remain low, corporations may be able to continue borrowing at the pace required to fund their operations and conduct share buybacks as they wish. The optics appear sound and, based on linear extrapolation of circumstances, there is no reason to believe that tomorrow will differ from yesterday. However, if things do change, this happy scenario being described by the analysts at Goldman Sachs may turn out to be naively optimistic and imprudent.

Let us consider Goldman’s four points one at a time:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets

Corporate debt as a share of cash flow may not be at the 2001 peak, but it is higher than every other instance since at least 1952. As seen in the chart below, this measure tends to peak during recessions, which makes sense given that cash flows weaken during a recession and debt does not budge. This argument is cold comfort to anyone who is moderately aware of the late cycle dynamics we are currently experiencing.

Using corporate debt as a share of corporate assets as a measure of debt saturation suffers from a similar problem. The pattern is not as clear, but given that the value of corporate assets tends to decline in a recession, this metric does not offer much confidence in current conditions. While not at or above prior peaks, debt as a share of corporate assets appears somewhat elevated relative to levels going back to 1952. Unlike debt as a share of cash flow, this metric is not a helpful gauge in anticipating downturns in the economy.

  • Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period

Goldman’s claim is purely speculative. How does anyone know where the “equilibrium leverage” level is other than by reflecting on historical patterns? Yes, interest rates are abnormally low, but for them to continue being an on-going benefit to corporations, they would need to continue to fall. Additionally, those “stable cash flows” are an artifact of extraordinary Fed policy which has driven interest rates to historical lows. If the economy slows, those cash flows will not remain stable.

  • Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk

This too is a misleading argument. Goldman claims that the percentage of short-term debt as a share of total corporate debt has dropped from roughly 50% in 1985 to 30% today. The amount of corporate debt outstanding in 1985 was $1.5 trillion and short-term debt was about $750 billion. Today total corporate debt outstanding is $9.7 trillion and short-term debt is $2.9 trillion. The average maturity of debt outstanding may be longer today, but the nominal increase in the amount of debt means that the corporate refinancing risk is much bigger now than it has been at any time in history.

  • The corporate sector runs a financial surplus (income exceeds spending) which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

According to Federal Reserve data on corporate financial balances, the corporate sector does currently have surplus balances that are above the long-term average, but the chart below highlights that those surpluses have been declining since 2011. The recent boost came as a result of the corporate tax cuts and is not likely to be sustained. Historically, as the economic cycle ages, corporate balances peak and then decline, eventually turning negative as a precursor to a recession. If corporate financial surpluses continue to erode, capital expenditures are likely at risk as has been the case in most previous cycles.

Summary

In a recent speech, Dallas Fed President Robert Kaplan stated that the high ratio of corporate debt to U.S. GDP is a concern and that it “could be an amplifier” if the economy turns down. A few days later, Fed Chairman Jerome Powell echoed Kaplan’s comments but followed them by saying, “today business debt does not appear to present notable risks to financial stability.”

“Today” should not concern Chairman Powell, tomorrow should. In that speech, entitled Business Debt and Our Dynamic Financial System, Powell contrasts some key characteristics of the mortgage crisis with current circumstances in corporate lending and deduces that they are not similar.

Someone should remind the Chairman of a speech former Chair Ben Bernanke gave on October 15, 2007, to the Economic Club of New York. Among his comments was this:

“Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy.”

That was exactly 12 months prior to Congress passing legislation to bailout the banking system.

As we suspected, you do not have to search too hard to find a Goldman Sachs report downplaying the risk of subprime mortgages in the year leading up to the subprime crisis.

In February 2007, Goldman penned a research report entitled Subprime Mortgage: Bleak Outlook but Limited Impact for the Banks. In that report, after elaborating on the deterioration in the performance of subprime mortgages, Goldman states, “We expect limited impact of these issues on the banks as bank portfolios consist almost entirely of prime loans.” Goldman followed that up in October 2007 publishing a report on financial crisis poster child AIG titled, Weakness related to possible subprime woes overdone.

Goldman Sachs and their competitors make money by selling bonds, being paid a handsome fee by corporate counterparties. Do not lose sight of that major conflict of interest when you read reports like those we reference here.

Even though it rots teeth and contributes to diabetes, Coca-Cola will never tell you that their soft drink is harmful to your health, and Goldman et al. will never tell you that corporate bonds may be harmful to your wealth if you pay the wrong price. Like most salespeople, they will always hype demand to sell to investors.

Banks will continue to push product without regard for the well-being of their clientele. As investors, we must always be aware of this conflict of interest and do our homework. Bank and broker opinions, views, and research are designed to help them sell product and make money, period. If this were not true, there never would have been a subprime debacle.

The Corporate Maginot Line

Since the post-financial crisis era began more than a decade ago, record low-interest rates and the Fed’s acquisition of $4 trillion of the highest quality fixed-income assets has led investors to scratch and claw for any asset, regardless of quality, offering returns above the rate of inflation. 

Financial media articles and Wall Street research discussing this dynamic are a dime-a-dozen. What we have not heard a peep about, however, are the inherent risks within the corporate bond market that have blossomed due to the way many corporate debt investors are managed and their somewhat unique strategies, objectives, and legal guidelines. 

This article offers insight and another justification for moving up in credit within the corporate bond market. For our prior recommendation to sell junk debt based on yields, spreads, and the economic cycle, we suggest reading our subscriber-only article Time To Recycle Your Junk. If you would like access to that article and many others, you can sign up for RIA Pro and enjoy all the site has to offer with a 30-day free trial period. 

Investor Restraints

By and large, equity investors do not have guidelines regulating whether or not they can buy companies based on the strength or weakness of their balance sheets and income statements. Corporate bond investors, on the other hand, are typically handcuffed with legal and/or self-imposed limits based on credit quality. For instance, most bond funds and ETFs are classified and regulated accordingly by the SEC as investment grade (rated BBB- or higher) or as high yield (rated BB+ or lower). Most other institutions, including endowments and pension funds, are limited by bylaws and other self-imposed mandates. The large majority of corporate bond investors solely traffic in investment grade, however, there is a contingency of high-yield investors such as certain mutual funds, ETFs (HYG/JNK), and other specialty funds.

Often overlooked, the bifurcation of investor limits and objectives makes an analysis of the corporate bond market different than that of the equity markets. The differences can be especially interesting if a large number of securities traverse the well-defined BBB-/BB+ “Maginot” line, a metaphor for expensive efforts offering a false line of security.

Corporate Bond Market Composition

The U.S. corporate bond market is approximately $6.4 trillion in size. Of that, over 80% is currently rated investment grade and 20% is junk-rated.This number does not include bank loans, derivatives, or other forms of debt on corporate balance sheets.

Since 2000, the corporate bond market has changed drastically in size and, importantly, in credit composition. Over this period, the corporate bond market has grown by 378%, greatly outstripping the 111% growth of GDP.  The bar chart below shows how the credit composition of the corporate bond market shifted markedly with the surge in debt outstanding. 

As circled, the amount of corporate bonds currently rated BBB represents over 40% of corporate bonds outstanding, doubling its share since 2000. Every other rating category constitutes less of a share than it did in 2000. Over that time period, the size of the BBB rated sector has grown from $294 billion to $2.61 trillion or 787%.

The Risk

To recap, there is a large proportion of investment grade investors piled into securities that are rated BBB and one small step away from being downgraded to junk status. Making this situation daunting, many investment grade investors are not allowed to hold junk-rated securities. If only 25% of the BBB-rated bonds were downgraded to junk, the size of the junk sector would increase by $650 billion or by over 50%. Here are some questions to ponder in the event downgrades on a considerable scale occur to BBB-rated corporate bonds:  

  • Are there enough buyers of junk debt to absorb the bonds sold by investment-grade investors?
  • If a recession causes BBB to BB downgrades, as is typical, will junk investors retain their current holdings, let alone buy the new debt that has entered their investment arena?
  • Will retail investors that are holding the popular junk ETFs (HYG and JNK) and not expecting large losses from a fixed income investment, continue to hold these ETFs?
  • Will forced selling from ETF’s, funds, and other investment grade holders result in a market that essentially temporarily shuts down similar to the sub-prime market in 2008?

We pose those questions to help you appreciate the potential for a liquidity issue, even a bond market crisis, if enough BBB paper is downgraded. If such an event were to occur, we have no doubt someone would eventually buy the newly rated junk paper. What concerns us is, at what price will buyers step up?  

Implied Risk

Given that downgrades are a real and present danger and there is real potential for a massive imbalance between the number of buyers and sellers of junk debt, we need to consider how close we may be to such an event. To provide perspective, we present a graph courtesy of Jeff Gundlach of DoubleLine.

The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies.

If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the subprime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the subprime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses.

As mentioned, if only a quarter or even less of this amount were downgraded we would still harbor grave concerns for corporate bond prices, as the supply could not easily be absorbed by traditional buyers of junk.   

Recommendation

Investors should stay ahead of what might be a large event in the corporate bond market. We recommend corporate bond investors focus on A-rated or solid BBB’s that are less likely to be downgraded. If investment grade investors are forced to sell, they will need to find replacement bonds which should help the performance of better rated corporate paper. What makes this recommendation particularly easy is the fact that the current yield spread between BBB and A-rated bonds are so tight. The opportunity cost of being wrong is minimal. At the same time, the benefits of avoiding major losses are large. 

With the current spread between BBB and A-rated corporate bonds near the tightest level since the Financial Crisis, the yield “give up” for moving up in credit to A or AA-rated bonds is a low price to pay given the risks. Simply, the market is begging you not to be a BBB hero.

Data Courtesy St. Louis Federal Reserve

Summary

The most important yet often overlooked aspect of investing is properly recognizing and quantifying the risk and reward of an investment. At times such as today, the imbalance between risk and reward is daunting, and the risks and/or opportunities beg for action to be taken.

We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.

While the topic for another article, a large reason for the increase in corporate debt is companies’ willingness to increase leverage to buy back stock and pay larger dividends. Investors desperate for “safer but higher yielding” assets are more than willing to fund them. Just as the French were guilty of a false confidence in their Maginot Line to prevent a German invasion, current investors gain little at great expense by owning BBB-rated corporate bonds.

The punchline that will be sprung upon these investors is that the increase of debt, in many cases, was not widely used for productive measures which could have strengthened future earnings making the debt easier to pay off. Instead, the debt has weakened a great number of companies.

Fixed Income Review – April 2019

The positive trends of the first quarter extended into April with broad-based total return gains across nearly every major fixed-income category. Only the safest corners of the bond markets posted negative returns last month, albeit those losses were quite minor in contrast with the positive returns since the end of 2018.

Returns in April, across the spectrum of indices, were not as impressive as those seen in the first three months of the year. No one expected those types of moves nor would anyone, having enjoyed them, expect them indefinitely. The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds, especially in credit-sensitive sectors, are becoming more obvious as we will discuss below.

As mentioned, the only two modest losers in April were Treasuries and securitized products (mortgages, asset-backeds, and commercial mortgages). Otherwise, the high yield sector again won the day head and shoulders above investment grade corporates, the next closest performer. According to the heat map below, like last month, all sectors are green across all longer time frames adding emphasis to the impressive rally seen since Christmas.

We would not speculate on the likelihood of this trend continuing, as odds favor a weaker performance trajectory. That does not mean poor performance, but risks rise with prices and spreads perched at historically tight levels.

The charts below illustrate the option-adjusted spreads (OAS) for the major categories in the corporate universe. They have all tightened dramatically since the end of the year. If we are correct that the spread tightening is largely done, then the preference would be to play for safety, and some interest carry for the next few months. In doing so, one may miss another unexpected move tighter in very risky high yield bond spreads; however, given current spread levels, one may also avoid increased odds of poor performance and possible losses.

Understanding that compounding wealth depends on avoiding large, damaging, emotional losses we would prefer to accept the risk of lower returns with high-grade securities while reducing our exposure to the riskier, more volatile sectors.

Although cheapening more dramatically than the Investment Grade (IG) sector in the fourth quarter, High Yield (junk) bonds recaptured much of that in the first four months of this year and in doing so returns junk bonds to (more than) full-value status.

The same can also be said for the lower credit sectors within the IG population. A long-term perspective offers proper context for where valuations are today relative to the past 25 years. The risk is clearly skewed to wider credit spreads and cheaper valuations (losses).

The Trend Continues

The recent tightening of spreads offers little new to discuss other than some deceleration of price and spread action. Importantly, and as recent articles have emphasized, this is a very late stage cycle rally. Risks are rising that corporate margin headwinds, slowing global economic activity, and a high bar for rate cuts given the optical strength of the economy limit the scope for price and spread gains in credit.

Overweighting lower rated credit sectors of the fixed income market is currently akin to the well-known phrase “picking nickels up in front of a steam roller.”

All Data Courtesy Barclays

Time To Recycle Your Junk

Invariably, investors who disregard where they stand in cycles are bound to suffer serious consequences” – Howard Marks

If you believe, as we do, that the current economic cycle is likely at a similar point as 2006/07, then you should consider heeding the warning of the charts we are about to show you.

The current economic cycle stretching from the market peak of 2006/07 to today started with euphoria in the housing markets and investors taking a general indifference towards risk-taking. In 2008, reality caught up with the financial markets and desperation fueled sharp drawdowns, punishing many risky assets. The recovery that began in 2009 has been increasingly fueled by investor enthusiasm. While the stock market gets the headlines, this fervor has been every bit as evident in the junk bond sector of the corporate fixed- income markets.

Has This Cycle Reached Its Tail illustrated how investor sentiment and economic activity has evolved, or cycled, over the last 12 years. We recommend reading it as additional background for this article.

The Popularity of Junk

Junk debt or non-investment grade securities also known as high yield debt will be referred to as “junk” for the remainder of this article. They are defined as corporate debt with a credit rating below the investment grade threshold (BBB-/Baa3), otherwise known as “triple B.”

Historically, buyers of junk debt were credit specialists due to the need for an in-depth understanding of the accounting and financial statements of companies that bear a larger risk of default. Extensive analysis was required to determine if the higher yield offered by those securities was enough to cushion the elevated risk of default. The following questions are just a small sample of those a junk investor would want to answer:

  • Will the company’s cash flow be sufficient to make the payments on the debt?
  • If not, what collateral does the company have to support bond holders?
  • What is the total recovery value of plant, property and other capital represented by the company?
  • Does the yield on the junk bond offer a reasonable margin of safety to justify an investment?   

Since the financial crisis, the profile of the typical junk investor has changed markedly. Gone are the days when the aforementioned specialized analysts, akin to accountants, were the predominant investors. New investors, many of whom lack the skills to properly evaluate such investments, have entered the high yield debt arena to boost their returns. We believe that many such investors are ill-prepared for the risk and volatility that tend to be associated with non-investment grade bonds when the economic cycle turns.

The advent of exchange-traded funds (ETF’s) has made investing in junk-rated debt much easier and more popular. It has opened the asset class to a larger number of investors that have traditionally avoided the sector or simply did not have access due to investment restrictions. ETF’s have turned the junk market into another passive tool for the masses.

The combination of investors’ desperate need for yield along with the ease of investing in junk has pushed spreads and yields to very low levels as shown below. While a yield of 6.40% may seem appealing versus Treasury bonds yielding little more than the rate of inflation, consider that junk yields do not factor in losses due to default. Junk default rates reached double digits during each of the last three recessions. A repeat of those default rates would easily wipe out years of returns. Even in a best-case scenario, an annual 2.5-3.5% default rate would significantly reduce the realized yield. The graph below charts yields and option-adjusted spread (OAS).

OAS measures the spread, or additional yield, one expects to receive versus investing in a like maturity, “risk-free” U.S. Treasury bond. It is important to note that spread is but one measure investors must consider when evaluating prospective investments. For example, even if OAS remains unchanged while Treasury yields increase 300bps, the yield on the junk bond also increases 300bps and produces an approximate 15% price decline assuming a 5-year duration.

Junk Debt Spreads (OAS) and Economic Data

Economic activity and corporate profits are well -correlated. Given the tenuous nature of companies in junk status, profits and cash flows are typically extremely sensitive to economic activity. The following graphs illustrate current valuations and guide where spreads may go under certain economic environments. The label R² in the graph is a statistical measure that calculates the amount of variance of one factor based on the other factor. The R², of .58 in the graph below, means that 58% of the change in OAS is due to changes in real GDP.

In the scatter plot below, each dot represents the respective intersection of OAS and GDP for each quarterly period. Currently, as indicated by the red triangle, OAS spreads are approximately 175 basis points too low (expensive) given the current level of GDP. More importantly, the general upward slope of the curve denotes that weaker economic activity tends to result in wider spreads. For instance, we should expect OAS to widen to 10% if a recession with -2.00% growth were to occur.

The following are scatter plots of OAS as contrasted with PMI (business confidence/plans) and Jobless Claims (labor market).  The current OAS versus the dotted trend line is fair given the current level of PMI and Jobless Claims. However, if the economy slows down resulting in weaker PMI and rising jobless claims, we should expect a much higher OAS. Note both graphs have a significant R².

As discussed earlier, frothy equity markets and junk spreads have rewarded investors since the financial crisis. The scatter plot below compares OAS to CAPE10 valuations. A return to an average CAPE (16) should result in an OAS of nearly 10. Assuming that such an event was to occur, an investor with a five-year junk bond could lose almost 30% in the price of the bond assuming no default. Default would harm the investor much more.

We finish up with a similar graph as we presented in Has This Cycle Reached Its Tail. A special thank you to Neil Howe for the idea behind the graph below.

The graph, using two year averages compares the U.S. Treasury yield curve and junk OAS. The yield curve serves as a proxy for the economic cycle. The cycle started with the blue triangle which is the average yield curve and OAS for 2006 and 2007. As the cycle peaked and the financial crisis occurred, the yield curve widened, and junk OAS increased significantly. Starting in 2009, recovery took hold resulting in a flattening yield curve and lower junk OAS. The current one month point denoted by the red dot shows that we have come full circle to where the cycle began over ten years ago.

Trade Idea

Given the unrewarding risk-return profile of junk bonds, we recommend investors consider reallocating from junk to investment grade corporates, mortgages or U.S. Treasuries. For those more aggressive investors, we recommend a paired trade whereby one shorts the liquid ETF’s (HYG/JNK) and purchases an equal combination of investment grade corporates (LQD) and U.S. Treasuries (IEI).

Had one put on the paired trade mentioned above in 2014, when junk yields were at similar levels, and held the trade for two years, the total return over the holding period was 16.75%. Similarly, such a trade established in January of 2007 and held for two years would have resulted in an approximate total return of nearly 38.85%.

Investment return data used in pair trade analysis courtesy of BofA Merrill Lynch US high yield and Corporate Master Total Return Indexes. Treasury data from Barclays.

Summary

Junk debt is highly correlated with economic activity and stock market returns. When potential default rates are considered with signs that the economic cycle is turning, and extreme equity valuations, investors should be highly attuned to risks. This is not to say junk bond holders will suffer, but it should raise concern about the amount of risk being taken for a marginal return at best.

If you have owned junk debt for the last few years, congratulations. You earned a return greater than those provided by more conservative fixed-income investments. That said, we strongly recommend a critical assessment of the trade. Math and historical precedence argue that the upside to holding junk debt is quite limited, especially when compared to investment grade corporate bonds that offer similar returns and expose the investor to much less credit risk.

At RIA Advisors, we have sold the vast majority of our junk bond holdings over the last month. We are concerned that the minimal spread over Treasuries does not nearly compensate our clients enough for the real risk that the current economic cycle is coming to an end.

Fixed Income Review – March 2019

The first quarter of 2019 offered one of the most powerful surges in risky asset valuations seen in history. Closing at 2506 on December 31, 2018, the S&P 500 proceeded to rise 328 points (14.37%) to 2834 in the first quarter. The near vertical leap skyward corresponds directly to the abrupt change in posture from the Federal Reserve (Fed) as they eliminated all threats of rate hikes in 2019. They took the further step of announcing a schedule to halt quantitative tightening (QT).

As might be expected, high yield credit was the best performing sector for the quarter with a total return of 7.26%. Somewhat counter-intuitively, U.S. Treasuries (+2.11%) also rallied for the quarter although they lagged all other major fixed-income sectors as shown in the table below.

For March, risk markets stalled slightly after the big run in the prior two months. Although posting returns of nearly 1%, high yield was the worst performer while investment grade was the best.

The contrast in performance between high-quality and low-quality bonds may be telling. In what could be a related issue, interest rate volatility in the U.S. Treasury market as measured by the MOVE Index spiked higher mid-month and had implications for the credit markets.

As shown in the tables below, only the BBB spread tightened slightly with all others widening by 1-3 basis points. Putting it together, despite solid total returns for the month, the spread widening tells us that corporate credit did not keep pace with falling Treasury yields in March, particularly at the end of the month.

From a macro perspective, the changes in Treasury yields and the yield curve raise broad concerns. Namely, are we nearing the end of the current expansion? As discussed in far more detail in our prior article, Yesterday’s Perfect Recession Warning May Be Failing You, the yield curve has a durable track record of signaling major changes in the economic cycle especially when it inverts (longer-term interest rates drop below short-term rates). When an inverted curve is considered with the end of a Fed rate hike cycle, the evidence becomes even more compelling. The Fed abruptly altered their outlook for monetary policy in March putting to rest any concern for further hikes. The market is now pricing for 1 or 2 rate cuts in 2019.

The last time we observed this combination of circumstances, an inverted curve and a market implying fed funds rate cuts, was ominously in late 2006. In October of last year, when the yield curve spread was decidedly positive, most economists including National Economic Council director Larry Kudlow pointed to this barometer and said we were nowhere near recession. The current market narrative now claims we should not pay too much attention to this important historical precedent. As opposed to trying to shape the narrative to suit our interests, we prefer instead to heed history. The odds are that this time is not different.

Time will tell.

All data sourced from Bloomberg and Barclays

Monthly Fixed Income Review – December 2018

The fourth quarter of 2018 was a bad year for lower rated, riskier fixed income products.

In review of December’s fixed-income performance as well as 2018 in general, there are a few key themes that are prevalent.

  1. Interest rates moved higher throughout the first three quarters of the year and then abruptly reversed course and reclaimed nearly 75% of the selloff from the first nine months (5, 7, 10 and 30-year U.S. Treasury bonds).
  2. After outperforming all other primary fixed-income sectors for the first nine months, high yield bonds collapsed in the final three months finishing the year with negative total returns.
  3. Investment grade corporate bonds and emerging market bonds were the worst performing sectors throughout the year losing roughly 2.50%.
  4. Without regard for the direction of interest rates, the yield curve continued to flatten as Fed policy and more recently economic concerns caused the short end (2-year Treasuries) to underperform and the long end (10-year and 30-year bonds) to outperform.
  5. December proved exceptionally strong for safe haven securities like Treasuries, municipal securities and mortgages helping turn those categories positive for the year.

There were numerous times throughout the year when our recommendation to take a conservative tack by moving up in credit and avoiding the more expensive and riskier fixed income categories seemed foolish. In hindsight, the description foolish should be replaced with smart.

Investors can draw a bright line at September 30, 2018 as a point of demarcation. Prior to that date, high yield and other risky sectors like leveraged loans, could do no wrong while every other fixed income asset class languished as interest rates rose. With the economy humming along, employment and hiring robust and inflation concerns burgeoning, the Fed was methodically hiking interest rates. The adjustable rate of interest on leveraged loans made them attractive in a rising rate environment and the higher coupons and shrinking supply of junk bonds (high yield securities) similarly made them appetizing to investors. The last thing investors were worried about in a strengthening economy was credit related losses.

Complacency peaked at the end of September, with fresh record highs in the stock market and favorable returns from its closest proxy, high yield debt. A variety of issues have since emerged as global growth is slowing rapidly and the benefits of domestic fiscal policy move past their point of peak contribution. Needless to say, optimism is waning. The chart below shows how high-yield debt languished in the final three months while safer sectors performed admirably.

As we have expressed throughout the year, there is a lot to worry about in the world and the United States is not immune to those concerns. Concurrently, U.S. markets have assigned expensive prices to the riskiest of assets. For all of 2018, we have urged readers to adjust their investment posture increasingly toward protecting capital. Although now the second longest in recent history, the current expansion has been the weakest on record as it was mostly promoted by artificial stimulus and incremental increases in all forms of debt. Temporarily supportive of growth, rising debt loads create their own headwind and eventually lead to instability. That is in fact what we appear to be witnessing.

The optimists will say that recent underperformance sets the stage for a terrific buying opportunity and that may well be, but value investors are more discerning. The hiccup in performance in the fourth quarter is likely a harbinger of more difficulties to come as China, Europe, Australia and Japan all demonstrate weakening trends in growth and troubling strains from imprudent debt accumulation. It is important to note that approximately 40% of U.S. corporate earnings come from foreign sales.

The United States may soon face similar issues given the sensitivity of our economy to high and rising debt. To the extent that the Fed has properly chosen to wean our economic decision-making off of crisis-era policies, albeit belatedly, those assets that have been the biggest beneficiaries of such policies should also brace to bear the burden of their removal. What we are beginning to see is the lagged effects of higher interest rates and less artificial liquidity as a result – the tightening of financial conditions.

The “tell” has been the Treasury yield curve. Using the spread between 2-year and 10-year Treasury yields, 2018 provided many insights. The 2s-10s curve spread declined throughout most of the year which encompassed both rising rates and falling rates. The price of money, the basis upon which all other assets derive their projections of value, implied that there was a growing concern for rate hikes and inflation (rates up) through the third quarter and then a growing concern for a recession (rates down) thereafter.

Higher risk investment credit is likely to languish for quite some time or at least until the trajectory of the economy becomes clearer. As revealed by high yield bond performance and the direction of interest rates, the trends of 2018 are clear. Our prior guidance of moving up in to higher quality credit and into safer categories of the fixed income markets still holds.

All data courtesy Barclays

Monthly Fixed Income Review – November 2018

The price depreciation of risky assets in the financial markets continued through most of November but took a breather late in the month. The rebound in the final week provided for month-end to month-end optics that were otherwise better than what one might expect had they been watching markets transpire day-to-day.

Performance across the fixed-income sector was reflective of the recent challenges that extended into November. The list of issues included the sell-off of General Electric stock and bonds, Brexit uncertainty and the devastation and financial uncertainty associated with the California wildfires. The market reaction to these events has been justifiably imposing and leaves investors to consider the anxiety-inducing potential for contagion risk.

Money flowed into the safety of Treasuries, mortgages and municipal securities (Munis) and out of corporate bonds and emerging market bonds. As for year-to-date performance, only munis and high-yield corporate bonds are positive at this point, and in both cases, just barely.  All other sectors are negative.

ETFs performed similarly but the Muni bond ETF, unlike the index, is now negative on a year-to-date basis. Somewhat surprisingly and concerning, the emerging market ETF (EMB) is down almost twice the index (-7.24% vs. -3.79%) on a year-to-date basis.

Corporate credit spreads widened meaningfully in November largely offsetting the decline in Treasury yields. Investors appear to be contemplating an imminent slowdown in corporate earnings growth and the associated rating implications. This will be an important story to follow given the large percentage of companies that are BBB, and near junk status. The decline in crude oil prices, down -33% from the early October high, among other languishing commodities raises further concerns about a broader global growth slowdown.

Looking in detail at high yield sector spreads, the best junk rating (BB) widened only modestly (+85 bps) off recent tight levels while the worst rating (CCC) widened substantially (+255 bps).

Considering the drop in the price of crude oil in recent months, an evaluation of the relationship between high yield spreads and oil prices is informative and troubling. As shown in the chart below, crude oil prices below $50 over the past four years are associated with significantly wider high yield spreads.

Finally, there has been a lot of recent discussion about various yield curves beginning to invert. In U.S. Treasuries, the 2y-3y part of the curve is now imperceptibly positive (less than 1 basis point), and the 2y-5y curve is slightly negative. Treasury yields and various curves are highlighted below.

In recent history, an inverted yield curve has implied the eventuality of a recession. Based on the financial media and research from Wall Street, the current yield curve trends are becoming worrisome for investors. While there are good reasons for an economy so dependent on activities associated with borrowing and lending to succumb to an inverted curve, the anxiety being projected is probably more troubling at this stage than the early phase of this event. It is important to watch but should not be a major concern just yet.

Given the volatility in stocks and other risky assets in the early days of December, it remains unclear whether investors should count on the traditional healthy seasonal performance to which they have become accustomed. Uncertainties about the economic and geopolitical outlook loom large, urging a cautious approach and defensive posture in the fixed-income sector. Safer sectors, such as Treasuries, MBS and munis might continue to benefit if recent market turmoil continues.

Data source: Barclays

Monthly Fixed Income Review – October 2018

October 2018 was decidedly a “risk-off” month and posed a challenge for every asset class within the fixed-income market. In terms of total return, U.S. Treasuries performed the best (down -0.48%) while investment grade corporates, high-yield and emerging market bonds all posted losses of over 1%. For emerging markets, it was the worst monthly performance since November 2016 and for high-yield, the worst since January 2016. Year-to-date, however, only the high-yield sector remains positive up +0.96%.

A new addition to the monthly fixed-income review is a composite of spread changes as seen in the table below. The data in this table are option-adjusted spreads (OAS). Positive numbers reflect spread widening or higher yields relative to the benchmark which is what normally occurs in months of poor performance. Negative numbers are spread tightening which is constructive. The OAS is measured in relation to the U.S. Treasury benchmark curve.

As illustrated in the table, most OAS spreads are wider across every time frame but not dramatically so. The fact remains that in a historical context, spreads remain very tight to the benchmark. As a point of comparison, current high-yield spreads are 3.71% (371 basis points) above the benchmark curve. In January 2016, they were 7.33% above the benchmark.

In a rather unusual turn of events, despite the sell-off in equity markets, Treasury yields uncharacteristically rose. Over the course of the past 30 years, when we have seen stress emerge in risky assets like that which occurred in October, U.S. Treasuries experience a flight-to-quality bid and yields fall. One could argue that October was an anomaly, but the same thing happened this past February and March.

This irregular relationship may be due to one of a couple of factors, some of both or another unidentified dynamic. Either (1) the correction in equity markets did not stir investors’ fear of a deeper correction given the strength of the economy or (2) on-going concern about heavy U.S. Treasury supply prevented yields from falling. In any event, it is highly unusual and may represent a troubling change in the contour of the markets. The absolute level of interest rates remains low by historical measures but after nearly 10 years of zero-interest rate policies and little volatility, it is the change in rates that matters most to investors and borrowers. Similar increases in rates in prior periods were destabilizing to the equity markets.

The implications of higher interest rates are beginning to show in housing and auto activity. Neither industry, both vital to economic growth in the recent expansion, is collapsing but both are demonstrating a clear weakening trend. In the modern age of excessive debt, this is how topping markets typically progress.

October unveiled another bout of higher volatility, higher interest rates and falling asset prices. This may be a temporary setback but given the age of the cycle, how tight credit spreads are, and the economy’s dependence on debt, we would not advise throwing caution to the wind.

 

A Preferred Way to Generate Yield – Part 2 Trade Idea

The following article expands on, A Preferred Way to Generate Yield, by exploring the preferred shares of Government Guaranteed Agency-Backed Mortgage Real Estate Investment Trusts (REIT) and discussing a compelling trade idea within this sector. Neither the common nor the preferred equity classes of this style of REIT are widely followed, which helps explain why the opportunity of relatively high dividends without excessive risk exists.

What is a Mortgage REIT?

Real estate investment trusts, better known as REITs, are companies that own income-producing real estate and/or the debt backing real estate. REITs are legally required to pay out at least 90% of their profits to shareholders. Therefore, ownership of REIT common equity, preferred equity and debt requires that investors analyze the underlying assets and liabilities as well as the hierarchy of credit risks and investor payments within the capital structure.

The most popular types of REITs are called equity REITs (eREIT). They own apartment and office buildings, shopping centers, hotels and a host of other property types. There is a smaller class of REITs, known as mortgage REITs (mREIT), which own the debt (mortgage) on real-estate properties. Within this sector is a subset known as Agency mREITs that predominately own securitized residential mortgages guaranteed against default by Fannie Mae, Freddie Mac, Ginnie Mae and ultimately the U.S. government.

The main distinguishing characteristic between eREITs and mREITs is in their risk profiles.  The shareholders of eREIT securities primarily assume credit risk associated with rising vacancies and declining property values. Most mREITs, on the other hand, take on less credit risk. Instead, their dividends are largely based on interest rate risk or the yield spread between borrowing rates and the return on assets. Agency mREITS that solely own agency guaranteed mortgages take on no credit risk. Mortgage and equity REITs frequently employ leverage which enhances returns but adds another layer of risk.

Mortgage REIT Capital Structures

MREIT’s use debt, common equity, preferred equity and derivatives to fund and hedge their portfolios. Debt is the largest component of their capital structure, often accounting for more than 75% of the financing. Common equity is next in line and preferred equity is typically the smallest. The REITs choice of financing is generally governed by a balance between cost and desired leverage.

When a REIT issues common or preferred equity, leverage declines. Conversely, when debt is employed, leverage rises. The decision to increase or decrease leverage is often a function of balance sheet preferences, hedging strategies, market views and the respective costs of each type of financing. The choice between preferred and common is frequently a function of where the common stock is trading versus its book value as well as the financing costs and liquidity of the two options.

Selecting Agency mREIT Preferred Shares

Agency mREIT (again holding predominately government-guaranteed mortgages) preferred shares currently offer investors a reasonable return with manageable risk. In the current environment there are two primary reasons why we like preferred securities versus their common shares:

  • Discount to Book Value- Currently, several of the Agency mREITs that offer preferred alternatives are trading at price -to- book values below 1.0. While below fair value, we are worried shareholders might get diluted as they are at or near levels where new equity was issued in the past. We prefer to buy the common shares at even deeper discounts (in the .80’s or even .70’s) for this reason. Discriminating on price in this way offers a sound margin of safety where the upside potential is enhanced and risk of new share issuance diminished.
  • Interest Rate Risk- The Fed is raising rates and the yield curve is generally flattening. Profitability of mREITs is largely based on the spread between shorter-term borrowing rates and longer-term mortgage rates. As this differential converges, mREIT profitability declines. Also, as mentioned in our Technical Alert – 30 Year Treasury Bonds, longer-term yields might be reversing a multi-decade pattern of declining yields. While the funding spread is a key performance factor, rising yields introduce complexities not evident in a falling rate environment. Namely, hedging is more difficult and asset prices decline as rates rise. While we still think probabilities favor lower yields, a sustainable break in the long-term trend must be given proper consideration as a risk.

Before selecting a particular REIT issuer and specific preferred shares, we provide a list of all Agency mREIT preferred shares that meet our qualifications.

Data Courtesy Bloomberg

As shown in the Yield -to- Worst column (far right), the lowest expected yields are somewhat similar for all of the issues with five or more years remaining to the next call date.

To help further differentiate these issues, the table below highlights key risk factors of the REITs.

Data Courtesy Bloomberg

The bullet points below describe the four factors in the table:

  • Leverage Multiple– This is the ratio of total assets to common and preferred equity. Higher leverage multiples tend to result in bigger swings in profitability and the potential for a reduction in common and preferred dividends. It is important to note that leverage can change quickly based on the respective portfolio managers view on the markets.
  • Price -to- Book Value (P/B)– This is the ratio of the market capitalization of the common stock to the value of the assets. As the P/B approaches fair value (1.00) the odds increase that common or preferred equity may be issued, putting shareholders at the risk of dilution. The column to the right of P/B provides context for the range of P/B within the last five years.
  • 1 and 3 Year Price Sensitivity– This measures the change in book value as compared to the change in U.S. Treasury yields over selected time periods. This is an indication of hedging practices at each of the firms. The lower the number, the more aggressively they are hedging to protect against changes in yields. This measure, like leverage, can change quickly based on the actions of the firm’s portfolio managers.
  • Preferred as a Percent of Total Equity– This metric offers a gauge of the percentage of preferred shares relative to all equity shares. Preferred shareholders would rather this ratio be small. However, if the number is too low versus competitors, it might mean that preferred shares will be issued soon which would temporarily pressure the price of existing preferred shares.

Trade Idea

Given the current interest rate volatility and the potential for large binary moves in mortgage rates, we think Two Harbors Investment Corporation (TWO) appears to present the least overall risk based on the measures above. In particular, we are focused on their aggressive hedging strategy which has resulted in the lowest interest rate sensitivity over the one and three year time periods. A closer look at performance since June 2016, the point at which interest rates began to rise, also argues in favor of TWO as they have produced superior risk-adjusted total returns.

Data Courtesy Bloomberg

We are largely indifferent between the preferred issues of TWO (A, B and C) shown in the first table. The investor must choose between a preference for a higher coupon and a price above par ($25), and a lower coupon but price below par. On a total return basis, they yield similar results.

TWO spun off Granite Point in the fourth quarter of 2017 and therefore data related to that transaction was adjusted in the table to compensate for the event.

Disclaimer: This material is subject to change without notice. This document is for information and illustrative purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action, including without limitation as those terms are used in any applicable law or regulation.

A Preferred Way to Generate Yield

In the current environment investors must dig a little deeper and into less traversed areas of the capital markets to find value. In this article we provide a base knowledge of preferred equity shares, discuss the benefits and risks associated with owning them, and provide comparisons versus other asset classes. This article lays the groundwork for a forthcoming article that will analyze a sub-sector of the preferred market and make a specific trade recommendation.

Fixed-income investors in search of stable income and sufficient yield but wary of excessive risks are likely settling for assets that are sub-optimal. For instance, High-yield corporate debt yields have fallen to near record low levels and yield spreads versus safer fixed-income assets are at their tightest levels in at least the last 20 years. As stated in “High Risk in High Yield” – “As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.”

Equity investors can find somewhat dependable, high-single-digit/low- teen dividend yields in the Master Limited Partnership (MLP) and Real Estate Investment Trust (REIT) sectors. The primary risk of these investments is price volatility which can frequently negate the dividend and much more in adverse conditions.

Fortunately for higher income seekers, there is the preferred stock sector that lies between equity and fixed- income assets in corporate capital structures. This sector tends to be largely underfollowed and not well understood. Because of its relative obscurity and inefficiencies, it can present rewarding options versus other highly followed markets.

What is Preferred Stock? 

Preferred stock is a class of equity issued primarily by financial companies. In a textbook corporate capital structure, preferred shares are a hybrid of debt and equity. In the event of a corporate default, preferred shareholders have a claim on the company’s assets that is secondary to unsecured creditors, such as debt holders, but superior to common equity holders. This hierarchy applies to the distribution of dividends in the normal course of business as well. Debt coupons are paid in full first, then preferred dividends and lastly common equity dividends.

To help offset the risk of non-payment of a preferred dividend, most issues are cumulative, meaning that any missed dividends must be paid before any common equity dividends are paid.

Preferred stock is most commonly issued at a $25 price (par value) and price changes from that point are based on changes to the dividend yield. For example, if a company’s credit conditions are deteriorating or if interest rates in general rise, the price of preferred shares will decline to produce a higher current dividend yield. Prices of preferred shares tend to be relatively stable compared to underlying equity shares. In this respect they are much more bond-like, with price changes a function of the general creditworthiness of the issuer, supply and demand for the issue and the general level of interest rates.

Unlike bonds, most preferred offerings do not have a fixed maturity date.  However, most issues are callable, which allows the company to repurchase the shares at par ($25) after a specified call date. Dividends paid on preferred shares are taxed as long-term capital gains, in contrast with bond coupons which are taxed as income.

The following are key risks to preferred shares:

  • Callable- The ability of the issuer to call, or repurchase, the securities at par ($25) is a risk if the shares are trading above $25. Obviously, the incentive to call preferred shares increases as the price rises. In assessing this risk, the yield – to -call should be calculated.
  • Interest Rate Risk- Like bonds, the price of preferred shares will rise as interest rates fall and fall as rates rise.
  • Credit Risk- Preferred shares fall behind debt in the credit structure. As such, the loss in the event of default could be severe. Further, deterioration of a company’s credit situation will likely push prices lower.
  • Voting Rights- Preferred shareholders do not have voting rights and therefore the holder’s influence on the company’s management is greatly limited.
  • Liquidity- Shares are not as frequently traded as those of common stock. Therefore, bid/offer spreads can widen at times. For those looking to trade in large share blocks, patience over a longer period is required, a contrast with the immediacy of execution for most common shares.

Performance and Risk Comparisons

The table below compares total return performance and yields for the ETF’s of preferred shares and other comparable asset classes. We include a modified Sharpe Ratio which calculates the current dividend/coupon yield to price volatility (risk). This ratio provides a gauge of the amount of risk incurred per unit of dividend. The traditional Sharpe Ratio is backward looking, comparing prior total return performance versus volatility over the same period.

Performance over the last five years has favored preferred shares over corporate debt and has been mixed versus higher yielding equity choices. Importantly, if we presume that price volatility stays at current levels, preferred stocks offer the highest dividends/coupon per level of risk (modified Sharpe).  It is important to note that volatility has been abnormally low for all asset classes over the last five years, and investors in all of the assets shown should expect and account for higher volatility going forward.

Summary

Since preferred shares are not widely followed, they can offer investors a value proposition that is elusive in the more traditional markets at times. However, like all higher-yielding securities, they offer above-average yields for a reason. In the case of preferred shares, this is attributable to lower levels of liquidity, and the real and present danger of credit risk. Given the credit assessment required to invest in preferred shares, experience in the fixed- income markets is beneficial in assessing the risks.

As stated above, financial companies are among the most frequent issuers of preferred shares. As such, a bank/financial system-centric economic crisis as experienced in 2008 could be devastating. The preferred ETF (PGF) declined nearly 70% through 2008 and early 2009. Once the Fed halted the decline in the financial sector with the provision of excess liquidity, bailouts, and favorable accounting changes, the sector roared back. By January 2010, PGF had totally recovered all losses while the ETF representing equities of the financial sector (XLF) was still down over 50% from its 2008 highs. Importantly, PGF made all dividend payments during the crisis, and the dividend amounts were on par to slightly higher than those preceding the crisis.

As mentioned, we will soon follow-up to this article with a recommendation of a unique preferred sector and specific shares.

 

High Risk in High Yield

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

  • The upside of owning this Tesla bond is 6.29% annually
  • The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
  • Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

  • What is driving HY to such returns?
  • How much lower can yields on HY debt go?
  • Is further spread tightening possible?
  • What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

  • HY yields fall to their minimum of the last three years
  • No change in yields
  • HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.

Summary

An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!

Monthly Fixed Income Review – September 2018

September’s surge higher in benchmark interest rates set the stage for a challenging month in the fixed-income markets. In our broad asset class categories, as shown below, there were two exceptions as high yield and emerging markets had a solid month of performance. On a year-to-date basis, only the high-yield sector is positive. Similar performance data was observed in the popular ETF’s for these sectors as shown in the second table.

Short term interest rates continue to march higher in response to the hawkish message being telegraphed by the Federal Reserve (Fed). At the same time, the long end of the yield curve remains range-bound although in September yields moved back to the upper end of that range with 10-year U.S. Treasury note yielding 3.06% and the 30-year U.S. Treasury bond at 3.21%. The move across the term structure of interest rates was parallel and for the first time since February, the 2-10s yield curve did not flatten. The chart below illustrates this shift in rates across the Treasury curve for the month of September.

The Federal Open Market Committee (FOMC) meeting at the end of the month produced few surprises and maintains that the Fed Funds target rate will top out between 3.25-3.50% in early 2020. The trajectory of Fed rate hikes suggests another move in December, three rate hikes in 2019 and one more in 2020. If maintained, that path means that interest rates at the short end of the yield curve will continue to rise and argues for an inverted yield curve in the not too distant future. Although an inverted yield curve has in the past implied a looming recession, Fed Chairman Powell and his colleagues on the FOMC are not yet expressing any concerns.

With that backdrop, it seems plausible that the outlook for fixed-income remains challenging as rising interest rates will continue to keep pressure on returns. At the same time, the consensus view is that the economy will remain strong which should be supportive of credit markets. Evidence of this dynamic is showing up in the performance differential between high yield credit and most other fixed-income sectors. As discussed in prior months, part of the performance in high yield is due to falling supply, a shorter duration profile and other technical factors.

The chart below shows the differential between spreads on BBB-rated credits, the lowest rung of the investment grade universe, and BB-rated credit, the highest rung of junk debt. Amazingly, at a mere 73 basis points, that difference is now very close to the historic low levels observed in the heady months leading up to the financial crisis of 2008. It is also over 100 basis points below the average for the last 12 years.

Emerging market (EM) credit bounced back from a poor August but the rebound seems unlikely to be durable. There remain a multitude of factors which urge caution including tight U.S. dollar funding conditions, on-going trade tensions as well as macro problems in several EM countries. Furthermore, this backdrop is creating the need for counter-measures (rate hikes) by the central banks of affected countries. While that may help matters in the near term as was the case in September, it may also create adverse conditions in terms of the outlook for economic growth. Capital outflows remain a significant risk until some of these issues are meaningfully relieved.

All Data Courtesy Barclays

Bubbles and Zombies

They say nobody rings a bell at the top of the market. But whether this is the top or not, two prominent market observers and historians, Robert Shiller and Edward Chancellor, are expressing concern.

First, Shiller warns readers not to take big increases in earnings too seriously because earnings are volatile.

Everyone knows that stock prices have risen dramatically since 2009. A $100 investment in the S&P 500 in 2009 has grown to nearly $400 at the end of August 2018. But Shiller reminds us that earnings have grown dramatically too. In fact, “real quarterly S&P 500 reported earnings per share rose 3.8-fold over essentially the same period, from the first quarter of 2009 to the second quarter of 2018,” according to Shiller. Prices, in fact grew a bit more slowly than earnings since the end of the crisis.

So should we think stocks are reasonably priced since earnings have grown at the same pace as prices? Not so fast, Shiller says. Earnings, the difference between two other data sets — revenues and expenses, are volatile, and cyclical. Rapid rises in earning are often followed by a return to long term trends or subpar levels. Such episodes have occurred more than a dozen times in U.S. stock market history.

Earnings can grow dramatically from things like “panicky demand” for U.S. goods from Europeans at the beginning of World War I. This led to political calls for “wealth conscription” or a heavy taxation on war-related profits. At that time stock prices didn’t follow profit advances as investors seemed to realize those gains would be short-lived.

In the “Roaring ‘20s,” however, emergence from a “war to end all wars” and a spirit of freedom and individual fulfillment spurred stock prices by Shiller’s lights. And this, of course, led to a crash at the end of the decade.

Another period where price gains outstripped earnings gains was 1982-2000. Real stock prices increased 7.5-fold, while real annual earnings only doubled, according to Shiller. Indeed the S&P 500 Index delivered an eye-watering 17% compounded annual return from 1982 through 2000, mostly on the back of multiple expansion (the increased price investors are willing to pay for underlying earnings).

In the next period, from 2003 through 2007, real corporate earnings per share almost tripled, but the real S&P 500 didn’t manage a double, because, as Shiller puts it, “investors apparently were unwilling to repeat their mistake in the years leading to 2000, when they overreacted to rapid earnings growth.”

After the 2008 financial crisis, which decimated earnings and prices, both have increased dramatically in tandem. Shiller can’t easily analyze investor psychology to know why, but he thinks it must be rooted in the “public’s loss of healthy skepticism about corporate earnings, together with an absence of popular narratives that tie the increase in earnings to transient factors.” In other words, nobody think earnings will go down dramatically or that their recent increase might be tied to something that can’t last.

Shiller doesn’t know if this is a bubble. He asks the question initially, but doesn’t answer it completely. I suspect that’s because Shiller thinks bubbles rest more on narratives and human psychology than on things like interest rates, and he can’t find a compelling narrative currently. But Edward Chancellor thinks record low interest rates since the financial crisis have produced bubbles galore and zombies, meaning overpriced assets and unproductive companies sustained only by low rates.

Chancellor, concentrating less on psychology in his recent article, reminds us of Adam Smith’s remark that “the ordinary price of land….depends everywhere upon the ordinary market rate of interest.” That’s because one discounts future income by the interest rate to arrive at the present value of an asset. The lower the rate, the higher the present value, and vice versa. Unfortunately, central bankers refused to accept this Smithian calculation after the collapse of Lehman Brothers. And so, they have kept rates so low for so long that they have created bubbles in industrial commodities, rate earths, U.S. farmland, Chinese garlic bulbs, fine or not-so-fine art, vintage cars, fancy handbags, super-city properties from London to Hong Kong, long-dated government bonds, listed and unlisted technology stocks, and the broader American stock market. Finally, Chancellor wonders whether low rates have encouraged a cryptocurrency bubble.

U.S. stocks are very expensive on dependable valuation measure such as total market value relative to GDP and on replacement cost basis (Tobin’s Q) compared to historic levels. American companies have also been on a borrowing binge. The problem is the economic rebound has been lackluster, and Chancellor blames easy credit and zombie corporates for this. Usually, a severe recession washes out weak companies, and investors reallocate capital to productive enterprises. “Business failures are essential to the recovery.”

Low interest rates have allowed companies that would have otherwise gone out of business to stay alive, and this has caused a tepid recovery. Chancellor notes the cumulative default rate on junk bonds during the entire recession was 17%, or “around half the level of the two previous downturns.” And while central bankers might view this as a victory, he views it as the cause of economic weakness.

The lessons for investors are to remain vigilant about stock valuations and higher yielding bonds. At some point the zombies will not be able to sustain themselves any longer. And that’s when having a good financial plan and asset allocation will help.

Seeking Alpha Exclusive Interview

On September 7th we were one of three investment professionals interviewed on Seeking Alpha’s Marketplace about the markets, the Federal Reserve and other topical issues. Please enjoy our contribution to the conversation.

Summary

The Fed’s annual Jackson Hole Symposium is over; what should investors look out for now?

For the near term, interest rates will continue their steady, gradual rise, says Chairman Powell. Our authors agree.

The markets’ trajectory keeps going up – when will it fall, and what will be the catalyst?

Look for opportunities in high yield and China.

With the Federal Reserve’s 2018 Jackson Hole Economic Symposium now over, markets continuing to hit new highs, and the economy seemingly humming on all cylinders (lots of people are employed, corporate profits are strong, and the Q2 gross national product was just north of 4%), we thought it would be a good time to check in with some of our macro-minded experts on Marketplace to get their take on interest rates, inflation, and where the economy might be headed next (just how close are we to a recession, anyway?). The authors we spoke to agree that rates will continue to rise gradually and steadily in the near term; that inflation risk, while small at this point, would be problematic for investors; and that, as common sense would dictate, the timing and severity of recessions is tough to pin down. They also propose some timely investing ideas to consider in the current environment, including high-yield instruments and a contrarian play on Chinese stocks. To find out more about how our authors are thinking about the current state of the economy and what investors should be watching for, keep reading.


Seeking Alpha: Federal Reserve Chairman Jerome Powell said at Jackson Hole that he expects rate hikes to continue. Do you foresee the two planned additional hikes coming this year? When do you think the Fed will stop raising interest rates?

Lance Roberts: The Fed under Jerome Powell has been very clear that they intend to keep raising rates at a gradual but steady pace. Real rates remain very low and stimulative relative to the extent of the economic recovery. That should fuel rising levels of inflation, especially given the recent rounds of fiscal stimulus at a time of full employment. The current circumstance offers further incentive for the Fed to maintain the path of rate hikes. Powell likely wants to build room to employ traditional monetary policy stimulus while the economy is giving him the latitude to do so. Ultimately, the stock market is the Fed’s barometer on terminal Fed Funds and will tell Powell when enough is enough.


SA: Why are market expectations different from the Fed’s expectations, according to the Fed’s most recent dot plot?

LR: We recently wrote extensively about this divergence in an article we penned for our Marketplace community: “Everyone Hears The Fed… But Few Listen.” One of the key takeaways from the article was as follows: “Market participants and Fed watchers seem to have been too well-conditioned to the PhD-like jargon of Greenspan, Bernanke, and Yellen and fail to recognize the clear signals the current Chairman is sending.” In short, since the financial crisis, the market has become accustomed to a Fed that has failed to deliver on rate hike promises. That seems to have changed with plain-speaking Chairman Powell.


SA: What’s the deal with inflation? Is the Fed being too complacent about inflation risk and their ability to “control it” at all costs? What are the odds of inflation upside?

LR: Yes! Yes! And who knows. First, it is important to clarify that rising prices are a symptom of inflation caused by too much money in the economic system. Given the actions of central bankers over the past 10 years, there is no question that condition exists on a global scale as never before. The manifestation has been different in this cycle than in the past and is showing itself in asset prices as opposed to the costs of goods and services. The biggest risk, albeit small at this point, is the combination of inflation and recession (stagflation). In this event, the Fed would be forced to reduce liquidity and raise rates. This is a scenario that has not been witnessed in decades and would be a difficult combination for most stock/bond investors.


SA: There’s a chart we saw recently that shows the S&P 500 steadily climbing to dizzying heights over the past decade. At what point do you think the Fed tightening will derail the S&P 500 and the bull market?

LR: Market valuations are clearly at historical peaks. It is being driven largely by behavioral tendencies and importantly central bank liquidity. As the Fed further reduces liquidity and the ECB and BOJ begin to take similar steps, the odds increase that equity markets falter. We are already seeing the effects of reduced liquidity in Turkey and other emerging market nations. That said, picking a date is a fool’s game as this market seems to be very good at ignoring reality.


SA: Recession: are we there yet? How close (or far) are we from an economic slump?

LR: We have had some close calls since 2010, especially in late 2015 and early 2016, but central bank intervention has delayed the rhythm of these cycles. In the same way, however, that suppressing forest fires eventually result in even more uncontrollable outbreaks, this seems to be a similar likelihood for the global economy. Debt (and leverage) is the lowest common denominator as a determinant for a recession and, again, the level of interest rates will eventually be the trigger. Rate hikes naturally are bringing us closer to that point, but the trigger is unknowable. Watch real rates, the yield curve, and credit spreads.


SA: The US dollar is key for many asset classes and critical for potential emerging market issues. What’s your outlook for the US dollar both near and long term?

LR: Given the global demand dynamics and the pressures being imposed by a Fed that maintains a path of rate hikes, the dollar should sustain it recent strength and continue to move higher in the short to intermediate term. Long term, the dollar outlook is problematic due to the amount of U.S. debt outstanding, the extent of money printing that will likely have to occur in order to avert a default and the converging global efforts by major economies (especially China) to reduce their reliance on dollar-based transactions.


SA: What would you say to investors who are looking to protect themselves against potential market and inflation risks?

LR: We own house and car insurance for events that are highly unlikely. Why shouldn’t we consider owning financial insurance, especially when the risks of a significant drawdown are substantial? As Falstaff said in Shakespeare’s King Henry the Fourth, “Caution is preferable to rash bravery.”

Monthly Fixed Income Review – August 2018

Monthly Fixed Income Review – August 2018

Interest rate and credit markets in the U.S. continued to demonstrate resilience in August despite rising global problems. With the exception of emerging market (EM) credits, all major fixed-income sectors registered positive returns for the month. The constructive momentum from July carried over and picked up steam in August. Meanwhile, EM gave back most of the prior month’s gain.

Data Courtesy Barclays

U.S. Treasuries – As the best performer of the month, the largest gains in the sector were in the long maturities of the yield curve. This is a reflection of the character of the persistent curve flattening. Maturities beyond 10 years had a total return for the month of between 1.33% and 1.64% while the 1-3 year sector was up only 0.33%. For the moment, the Treasury market is shrugging off the heavy supply pipeline needed to fund growing deficits.

Corporates – Strength in corporate fundamentals on display in the Q2 earnings parade no doubt played a role in last month’s performance. Investment grade (IG) performance again lagged that of the high yield sector for the third month in a row but supply dynamics largely help explain the divergence. High yield issuance fell for the 7th straight month while merger and acquisition driven issuance is fueling supply in the investment grade sector. Despite a typically quiet week heading into the Labor Day holiday, IG new issuance for the month was heavy at $86.5 billion, the third largest August on record. Looking ahead, those trends are likely to continue as September is normally the second largest issuance month behind May.

Emerging Markets – Fixed-income securities came under the same withering pressure that EM currencies and equity markets have seen since April. So far, there appear to be no signs of the stress letting up as the Trump administration and strengthening U.S. dollar continue to apply pressure. EM credit returns have been negative in six of the eight months this year and the word on every investor’s mind at this stage is “contagion”. The chart below offers a detailed look at the breakout of EM returns by broad geography and the progression of stress since the beginning of the year.

Data Courtesy Barclays  (EMEA – Europe/Middle East/Africa)

Even though the risks seem concentrated in just a few countries (Turkey, Argentina, Brazil, South Africa), the concern is that investors begin to treat all developing countries the same and reduce risk on a wholesale basis. It traditionally begins, as we are now observing, with weakness spreading across the more vulnerable EM countries and eventually engulfs even the stronger hands. If that scenario develops as it did beginning in 1997, it will bring with it a multitude of opportunities to acquire quality assets in those countries that are being unjustifiably beaten down. Those would include the stronger exporters with current-account surpluses like South Korea and Taiwan.

The following table provides returns for selected ETF’s that mirror the major fixed income asset classes.

Data Courtesy Barclays