Tag Archives: spread to Treasuries

Monthly Fixed Income Review – February 2019

The rebound in credit markets has been remarkable since the Christmas eve lows however it appears as though the fuel for the rally, optimism of a softened stance by the Federal Reserve (Fed) and a pending trade deal with China, is being priced in multiple times over. Every time a new headline about a trade deal, or dovish Fed-speak hits the wire, the market spikes (we probably have the genius of artificial intelligence and computer-driven algorithmic traders to thank for that).

Since late December, the Fed has clearly eased their outlook for future rate hikes and balance sheet reduction but they have yet to formalize a new stance. That may be coming in two weeks, as it appears likely that at the March 20th FOMC meeting a schedule for eliminating QT will be discussed.

As things stand now, the data on which the Fed claims to be dependent, says unemployment is at a historical low 4% and inflation is hovering around their 2% target. As an aside the deflationary ghost that seems to justify the Fed’s lust for more inflation has not been seen since the 1930’s.  “Crosscurrents” that also concern the Fed as mentioned by Powell in last week’s testimony likely include the usual suspects of China and Europe.

In the month of February, similar to what we saw in January, riskier fixed-income categories outperformed higher-quality categories. The best performing categories were high yield and emerging markets. Meanwhile, treasuries and mortgages posted a negative total return for the month.

With the exception of the investment grade corporate sector, ETF performance was generally in line with the indices.

In the name of prudence, it should be obvious that the levels at which riskier credits are trading should not be compelling to discerning investors, especially as economic data and earnings guidance points to the possibility of a further slowing of the U.S. economy.

As discussed in the past, the investment grade (IG) universe is becoming more and more heavily concentrated in the BBB credit category.

This weaker credit characteristic of the investment grade universe is bearing out in its performance. In the chart below, the dark blue line shows the difference between high yield (HY) and IG option-adjusted spreads. The light blue line is the difference between HY and IG credit default swap (CDS) pricing. CDS spreads are important because these are the instruments most heavily used by broker-dealers and other institutional accounts to hedge their corporate bond holdings. The chart shows HY spreads in both cases widening by more than IG which is to be expected. However, since October 2018 when turbulence hit the markets, if we look at the CDS ratio (HY CDS divided by IG CDS), IG underperformed high yield as credit spreads widened (red line). In other words, as HY CDS (the numerator) rose through December, IG CDS (the denominator) rose comparatively by more causing the ratio to drop from 5.6 to 5.1 (see table below).

This behavior is atypical as better credit quality generally outperforms weaker credits in a spread widening environment.  Higher credit quality should widen by comparatively less keeping the ratio somewhat stable.

Since year end, IG has outperformed as the market recovered. As the table and ratio changes reflect, IG CDS is trading with a higher beta to HY CDS. How else to explain this except to observe that so much more of the index is perched dangerously close to junk ratings and at a greater risk of losing investment grade status.

Economic stagnation would likely send a sizable portion of the triple-B rated bonds into Junkville. That would then create a problem in the credit slums as a large amount of newly rated junk bonds would cause spread widening in a land that is highly sensitive given current valuations. This is our assessment as to why we have seen the recent elevated ratio volatility between IG and HY bond CDS spreads.

The bottom line is that with the uncertainty in the current outlook, the length of the current recovery and the sudden, almost irrational bounce off the Christmas Eve lows, does taking risk in the credit sector make sense? We argue no and recommend either liquidating at these valuations, moving up in credit, or sit patiently on cash. Now is not a time to acquire credit risk.

Monthly Fixed Income Review – January 2019

Blowing the Call

Before reviewing January returns in the fixed-income markets, we digress for a moment to raise important questions about the character and integrity of financial markets nudged and cajoled by Federal Reserve (Fed) officials.

In the recent National Football League (NFL) playoff games, there were several occasions where poor or missed calls by the referees influenced the outcome of the game. Despite all of the technology, cameras, camera angles and new “Play Review” rules, NFL commissioner Roger Goodell acknowledged a significant and obvious missed call in the Rams-Saints game but said the game is, after all, “officiated by humans”. Fans and announcers, outraged at the errors, charged Goodell with avoiding the important issues on the matter and some have gone so far as to say Super Bowl LIII was “tainted”.

And yet in financial markets, we continually speak of the referees at the Fed as an omnipresent force that needs to be called upon to influence outcomes. In doing so, the Fed regularly chooses winners and losers in the capital markets with obvious intent. Is there a difference between the NFL referees and the Fed? Yes, of course, the economy and the welfare of the nation is infinitely more important than a football game. Is it proper? Legal? Most investors assume so since it is carried out at the Fed on a daily basis just as enthusiastically as it is at the Peoples Bank of (communist) China. Now for the hard question: Is it in the best interest of the public? The answer: No, it is not.

The January edition of our fixed income review reveals just as much about these nefarious interventions by the Fed in bond markets as we observed in equity markets over the past month. Our perspective and characterization of those interventions is out of consensus as most people see no harm (and great help) in the outside influences brought to bear. The problem is that whether immediately recognized or not, the Fed’s involvement in manipulating outcomes to their preference similarly damages their integrity and that of our markets and economy.

The difference is that the NFL, although not entirely owning up to the problem publicly, understands what is at stake and will likely take corrective action to minimize these issues in the future. The Fed does precisely the opposite delving ever deeper into the business of manipulating economic outcomes as if it is their obligation. For the Fed, their tone-deaf perspective presents far bigger problems for the dollar, interest rates, the deficit and a multitude of other matters that will reveal themselves gradually – and then suddenly – over time.

January Performance Overview

The change in the Fed’s policy posture between the December 19, 2018 and the recent January 30th FOMC meeting is stark. They went from a Fed intent on raising rates two to three more times in 2019 and having balance sheet normalization on “autopilot” to implying that they will remain on “hold” in terms of rates hikes and moderating the pace of balance sheet reduction. The dovish shift appears to have put to rest any concerns of overtightening, the primary narrative behind fourth quarter turbulence. Markets clearly started to believe in the Fed shift in later December and the positive momentum in risk sentiment carried markets through January.

For the month of January, every credit sector posted positive returns led by the riskiest categories of high yield, emerging markets and investment grade.

The story was the same for ETFs but with a few large variances from index performance owing to the uneven nature of flows quickly re-entering the riskiest classes.

January Market Move

A lot was made of the fact that December was the worst month of December for the stock market since the 1930’s. Using the same concept and to further highlight the strength of fixed income returns in January 2019, we compared last month with other Januarys over the past 30 years. Investment grade and high yield posted the third best month dating back to 1989 and emerging markets posted their fourth best since 1993 (earliest data available).

Drilling down a little deeper within the investment grade category, we chose to look at the spread tightening that occurred in the banking, technology and energy sectors in January. The chart below shows the three sectors with the broad aggregate IG option-adjusted spread. The black vertical line marks December 31, 2018.

Using similar context, the chart below highlights the price movements of the leveraged loan index since January 2016. Again, the black vertical line denotes December 31, 2018.


What the charts above reflect is the radical spread and price moves that took place as the Fed flipped their language and posture surrounding both future rate hikes and discussion about the pace of balance sheet normalization. What this suggests to us is not that the Fed is “data dependent” as they claim, but that they are entirely focused on assuaging market turbulence when it appears. Although anyone who watches sports cringes when a referee blows a call, no one is more humiliated than the referee himself. With the Federal Reserve, however, intentionally altering the game appears to be their daily objective.

All data courtesy: Barclays

Big Apartment REITs Aren’t Yielding Enough

The seven largest publicly traded apartment REITs are now paying dividend yields of less than 3.5%. The two largest — AvalonBay Communities and Equity Residential — are paying around 3.2%. Essex Property Trust, whose apartment buildings are all in California, is paying barely over 3%, roughly the equivalent of the 10-year U.S. Treasury Note. Historically, REITs have paid one full percentage point more of yield than the 10-year Note, and that means investors in apartments could be in for trouble if the yield on the 10-year Note doesn’t decline and/or the apartment landlords don’t increase their dividends.

Recent History of Apartment REITs

Among the different property types in real estate, apartments (sometimes called the “multifamily” sector) have done particularly well since the financial crisis. That makes some sense since homeownership went from the low 60% range to above 68% during the bubble period of 2003-2007, and the collapsed again to the low 60% range. Families that couldn’t stay in homes after the crisis went back to renting. Also multifamily new development stagnated, and a continued influx of educated people into big cities with limited apartment stock contributed to increasing rents.

At around the beginning of 2011, companies like AvalonBay Communities and Equity Residential, the two largest multifamily REITs, and their competitors began raising rents, and haven’t stopped since. In the early years of the recovery, those rent increases were sometimes more than 6% on a year-over-year basis. After a dip in the rate of increase in 2013-2014 to the high 3% range, rent increases moved up to nearly 6% again in late 2015 and 2016.


After declining down to 2%, rent growth has picked up for the past few quarters again. But publicly traded multifamily companies are increasing rent in the 2%-3% range on a year-over-year basis instead of the 6% range. The pattern for Avalon Bay is similar to those of its competitors.

This declining growth would make it difficult for Avalon Bay to increase its dividend despite its current comfortable coverage. Avalon Bay pays around $800 million in dividends annually, and generates around $1.2 billion in funds from operations. That’s  a difference of around $300 million But funds from operations doesn’t take long-term property upkeep and improvements into consideration. One percent of the stated value of the firm’s property — a modest annual upkeep charge — would be around $200 million. Some real estate analysts think 2% is a more reasonable annual charge for upkeep and maintenance. That would be around $400 million or more than Avalon Bay can afford while paying its current dividend.

Perhaps 2% is draconian for annual long-term capital expenditures, but it seems clear that Avalon Bay doesn’t have the ability to pay a dramatically higher dividend if it doesn’t experience more robust rent growth. This is also true for its large publicly traded competitors. Perhaps they could all boost their dividends by an amount that would equate to 4% at current stock prices, putting their yields a full percentage point above that of the 10-year Note, but not much more. And if the large public apartment REITs can’t boost dividends significantly at this point, it makes little sense to own them when their yield advantage over a 10-year U.S Treasury Note is so minimal — unless you think rates are going back down significantly.