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
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.
contrast, the ETF table below highlights some of the significant changes we
have seen since the beginning of August.
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.
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.”
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.
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.
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
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
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.
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
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.
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.
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.
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.
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.
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
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…”
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
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
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
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.
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.
are blowing in trouble from the obvious U.S.-China trade dispute but also from
Italy, Brexit, Iran, and Deutsche Bank woes.
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.
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
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.
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
All Data Courtesy Bloomberg and Barclays
Higher Rates Are Crushing Investors
There is an old saying that proclaims, “it’s not the size of the ship, but the motion of the ocean.” Since this is a family-friendly publication, we will leave it at that. However, the saying has a connotation that is pertinent to the bond market today. Much of the media’s focus on the recent surge in yields has been on the absolute increase in numerical terms. The increase in rates and yields, while important, fails to consider the bigger forces that can inflict pain on bond holders, or sink the ship. When losses accumulate and fear of further losses mount, volatility and other instabilities can arise in the bond market and bleed to other markets, as we are now beginning to see in the equity markets.
Since 1983, fixed-income investors have been able to put their portfolios on autopilot, clip coupons and watch prices rise and yields steadily fall. Despite a few bumps on this long path, which we will detail, yields, have declined gradually from the mid-teens to the low single digits.
In this piece, we discuss the effect that higher yields are having on debt investors today and compare it to prior temporary increases in yield. It is from the view of debt investors that we can better appreciate that the “motion” is much bigger today than years past.
The Motion of the Bond Ocean
As we alluded in the opening, the losses felt by bond investors cannot be calculated based solely on the amount that yields rise. For instance, if someone told you that yields suddenly rose by 1%, you have no way of estimating the dollar losses that entails for any investor or the entire universe of bond holders. For example, an investor holding a 1-month Treasury bill will have a temporary and inconsequential loss of less than 0.10%, but it will be erased when the bill matures next month. Conversely, a holder of a 30-year bond will see the bond’s value drop by approximately 20%. This example demonstrates why a bond’s duration is so important. In addition to duration, it is critical to know the cumulative amount of bonds outstanding to understand the effects of changes in yields or interest rates.
Comparing yield changes to prior periods without respect for duration and amount of debt outstanding is a critical mistake and has led to an under-appreciation of the losses already incurred by the recent rise in rates and the potential future losses if rates increase further. The importance of this analysis comes back to the central premise of an investor’s objective – wealth is most effectively compounded by avoiding large losses. In the end, we care less about the change in interest rates than we do the impact of that change on the value of a portfolio.
Amount of Debt Outstanding: Since 1993 total U.S. debt outstanding, including federal government, municipalities, consumers, and corporations have risen from about $14 trillion to nearly $60 trillion, a 318% increase as graphed below. The table below the graph compares the surge in outstanding debt among the various issuers of debt as well as the nation’s GDP.
Data Courtesy: Bloomberg
Duration of Debt Outstanding: The duration of a bond is a measure of the expected change of a bond’s price for a given change in yield. For example, the U.S. Treasury 10-year note currently has a duration of 8.50, meaning a 1% change in its yield should result in an approximate 8.50% decline in price. Since it quantifies the price change of a bond for a given change in interest rates, it affords a pure measure of risk. For simplicity’s sake, we omit a discussion of convexity, which measures the second order effect of how duration changes as yields change.
Think of duration as a fulcrum as shown below.
As illustrated, an investor of these cash flows would receive the weighted average of the present value of all of the expected cash flows at the three year mark.
Duration is a function of the current level of yields, the nominal coupon of the security, and the time to maturity of the debt issued.
The following graph highlights that the weighted average duration of total U.S. debt outstanding (including Federal, consumer, municipal and corporate) has increased by approximately 1.30 years to almost 6 years since 1993. All else equal, a 1% increase in yields today would result in an approximate 6.0% loss across all U.S. debt versus a 4.7% loss in the early 1990’s.
Data Courtesy: Bloomberg
The table above shows the changes in duration for various classes of fixed-income instruments since 1993. Consumer debt includes mortgages, credit cards and student loans. As an aside, the increase in yields since 2016 has caused the duration of mortgage-backed securities (MBS) to increase by over 3.0 years from 2.25 to 5.30 years.
Duration and Amount of Debt Outstanding
If we combine the duration and debt outstanding charts, we gain a better appreciation for how fixed-income risk borne by investors has steadily increased since 1993. The following graph uses the data above to illustrate the sensitivity of bond investors’ wealth to a 1% change in yields. For this analysis, we use the change in 5-year U.S. Treasury yields as it closely approximates the aggregate duration of the bond universe.
Data Courtesy: Bloomberg
The table below displays the way that the recent uptick in bond yields has been commonly portrayed over the prior few months.
Tables like the one above have been used to imply that the 2.13% increase in the 5-year U.S. Treasury yield since 2016 is relatively insignificant as three times since 1993 the trough to peak yield change has been larger. However, what we fear many investors are missing, is that the change in rates must be contemplated in conjunction with the amount of debt outstanding and the duration (risk) of that debt.
The table below combines these components (yield change, duration, and debt outstanding) to arrive at a proxy for cumulative dollar losses. Note that while yields have risen by only about two-thirds of what was experienced in 1993-1994, the dollar loss associated with the change in yield is currently about three times larger. Said another way, yields would have needed to increase by 9.73% in 1993-1994 to create losses similar to today.
Data Courtesy: Bloomberg
We have often said that our current economic environment is much more sensitive to changes in interest rates because of the growth in debt outstanding since the financial crisis and the recent emergence from the ultra-low interest rate period that crisis produced. Although 5-year yields have only risen by 2.13% from the 2016 lows, losses, as shown above, are accumulating at a faster pace than in years past.
Furthermore, because of the difference between the amount of debt outstanding and the actual currency in the economic system, most of that debt represents leverage. It is beyond the scope of this article to explore those implications but, as illustrated in the table above, rising rates will decidedly reveal the instabilities we fear are embedded in our economy but have yet to fully emerge.
If we are near the peak in interest rates for this cycle, then unrealized losses are likely manageable despite the anxiety they have induced. On the other hand, if we are in the process of a secular change in the direction of rates and they do continue higher, then nearly every fixed-income investor, household, corporation and the government will be adversely impacted.
VLOG: Rising Rates Send A Warning & Why It Matters
While it has been stated that rising interest rates don’t matter, the reality is that they do. I take a deeper look at the impact of higher rates across the financial and economic spectrum and the warning that rates are currently sending to investors.
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
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.
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.”
Why Foreigners Shun Higher Yielding U.S. Bonds : Reader Question – RIA Pro
Recently we received the following question from a reader and thought it might be helpful to answer it for all of our subscribers. The question is as follows:
“Who buys a French bond with a negative yield when they can buy a safer U.S. Treasury bond yielding over 2%?”
The simple answer: the economic incentive for a foreigner to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.
Following is a detailed analysis explaining the answer.
That question was recently posed following the publishing of Deficits Do Matter. In that article, we presented data showing the pace of foreign buying of U.S. Treasury securities had slowed considerably in recent years. Of concern, the amount of debt foreigners are currently buying is not keeping up with the increasing issuance of Treasury debt. Given that foreign holders are the largest investors in U.S. Treasuries, accounting for over 40% ownership, as well as their large holdings of corporate and securitized individual debts, this change in behavior should be followed closely.
Why are foreign investors shunning U.S. Treasuries despite significantly higher yields than many other sovereign debt issuers? The question is even more perplexing when one considers that U.S. Treasury securities are believed to be safer from a credit perspective and offer more liquidity than any bond outstanding, sovereign or otherwise.
When considering bonds of different countries, the analysis is not as simple as comparing yields. When factors such as foreign exchange (FX) rates and credit quality are factored in, the math becomes more complicated, and the results tell a very different story.
Buy and Hold
In this article, we walk through the calculations that buy and hold investors of sovereign bonds use to effectively compare yields on bonds from different countries. Before going into details, it is important to note that there are two other types of buyers and their decision making is different from that discussed in this article. One investor grouping consists of the banks, brokers and hedge funds that speculate on a short-term basis to take advantage of an expected change in yields. The other type of “investors” are the central banks and/or treasuries of countries that hold U.S. dollars for trade purposes. These dollar reserves are typically invested in highly liquid fixed income securities, with U.S. Treasuries generally the most desired.
Global bond mutual funds, pension funds and other types of institutional investors that buy foreign government bonds tend to hold them to maturity. These investors are constantly assessing yields, credit risk, liquidity status and many other factors to help them achieve the highest returns possible. This task is not as simple as comparing the stated yield of a German bund to a U.S. Treasury bond of similar maturity. As mentioned, two other important risk factors one must consider, assuming the investor holds to maturity, are expected currency exchange rate changes and credit risk.
Assume the perspective of a German-based sovereign bond fund. The German portfolio manager, when valuing various sovereign bonds, must take two steps to re-calculate yields so they are comparable on a risk-adjusted basis.
The first step is to quantify the credit risk. This is a relatively easy task as credit default swaps (CDS) provide a real-time market assessment of credit risk. These swaps are essentially insurance policies where the writer/seller of the swap receives semi-annual premium payments, and the buyer of the swap is entitled to be made whole if the bonds default. The less risky the bond, the lower the premium. Our German investor might buy a related CDS in conjunction with a Treasury bond to hedge the credit risk.
The second step is to gauge the foreign exchange risk. For our German portfolio manager to buy a U.S. dollar bond, he must first convert his Euros to U.S. Dollars. Going forward, each interest payment and the ultimate payment of principal the portfolio manager receives must be converted back from U.S. Dollars to Euros. The risk the portfolio manager bears is the changing FX conversion rate of future interest and principal payments from U.S. dollars back into Euros.
Our manager can assess and hedge the risk, if he chooses, using FX forward swaps. These swaps represent the “price” at which an investor can lock in an exchange rate between two currencies in the future. Investment banks facilitate a swap where mutually agreed upon future exchange rates can be negotiated. This transaction allows the investor to buy the foreign bond and establish certainty around the exchange rate at which future payments will be received and converted.
To walk through a transaction, let’s compare a 2-year German bund to a 2-year U.S. Treasury note. The yield on the German bund is currently -0.58% and the U.S. note yields +2.64%. At first blush, one might surmise that a German investor can pick up 3.22% (2.64% – (-0.58%) buying the 2-year U.S. Treasury. However, as we stated, the investor would then be assuming foreign exchange risk.
Currently, the two-year forward euro/dollar exchange rate is priced at 6.57% (3.23% annualized) higher than the spot exchange rate. If the Euro were to appreciate 3.23% each year, the previously stated 3.22% annual pickup in yield (benefit) would be entirely offset with a 3.23% currency loss, resulting in the German portfolio manager being largely indifferent between the two bonds.
In selecting the German bund over the U.S. Treasury, the investor is also taking on additional credit risk, as Germany is considered slightly riskier than the U.S. The current German two-year credit default swap (CDS) swap costs five basis points a year more than U.S. CDS. Factoring in the CDS swap, the new rate differential slightly favors the U.S. Treasury by 0.04%.
The table below provides this same analysis for Germany and four other countries.
As highlighted above in the Net Yield Difference column, investors in Japan are better off on a risk-adjusted basis (.21%) by buying their domestic 2-year bonds with a negative yield than buying 2-year U.S. Treasury notes at 2.64%. German and French investors are indifferent, while Italian and UK investors should favor U.S. bonds.
While the math can get confusing the important takeaway is as follows: For the countries shown above and many others not included in the table, the economic incentive to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.
Interest Rate Parity
This article is based on what economists call interest rate parity, a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
Financial theory, in general, rests on a bedrock that states that risk-free arbitrage opportunities, such as those shown above, should not exist. In reality, there are other factors such as capital requirements, liquidity concerns, and regulations that add costs and preclude some investors from participating in such opportunities and thus allow them to exist as highlighted above.
This analysis addresses the common misconception that U.S. Treasury bonds and notes offer significant relative value based solely on yield levels. As exhibited, there is little if any financial incentive currently for foreign buyers to choose U.S. bonds over European, British or Japanese bonds despite significantly higher yields on U.S. Treasuries. Required adjustments incorporating the foreign exchange component into the equation negates any optical advantage of higher yields in the U.S.
While there is certainly a yield that is attractive to foreign investors and will incentivize foreigners to fund U.S. deficits, based on the math that yield resides somewhere north of current levels. Either that or the U.S. dollar would have to strengthen further to offset the foreign exchange adjustments in play. A stronger dollar however presents other economic challenges beyond the scope of this discussion.
Considering the size of the current debt overhang in the U.S. and the increased supply of Treasuries projected to be coming forth over the next several quarters, this is an important and largely overlooked challenge. Each additional basis point required to meet funding needs raises the interest expense on the debt as well as the interest expense on all corporate, muni and individual new issues and floating rate debt. Given the excessive financial leverage employed by the U.S. economy, every basis point has a detrimental economic effect.
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
An Update On The U.S. Treasury Bond Breakout
Since the start of the year, I’ve been watching and showing that the “smart money” (commercial futures hedgers) have been bullish on U.S. Treasury bonds and bearish on crude oil, in direct contrast to the “dumb money” (large trend-following traders) and the mainstream financial community. Two weeks ago, I showed several charts that seemed to indicate that U.S. Treasury bonds were breaking out to the upside. As usual, I wasn’t making market predictions, but pointing out observations that I thought were worth paying attention to.
After their initial breakout from triangle patterns, Treasury bonds eased a bit as traders braced themselves ahead of last week’s Fed meeting. Since that meeting, however, U.S. stocks have resumed their sharp sell-off, which has helped to buoy Treasuries and create follow-through after their breakout two weeks ago.
As the chart below shows, the 30-year U.S. Treasury bond broke out of its triangle and appears to be gunning for its next major resistance level, which is the downtrend line that started in September 2017:
The 10-Year Note shows a similar pattern. If the 10-Year can break above its downtrend line in a convincing manner, it would give a bullish confirmation signal.
The 5-Year Note recently broke out of a channel/wedge pattern as well as its downtrend line that started in September, which is a bullish sign, as long as this breakout holds.
The 2-Year Note also broke out of a channel and is testing its downtrend line. If it can break above this resistance, it would be a bullish sign.
As I’ve been showing, the “smart money” or commercial futures hedgers are quite bullish on the 10-Year Note. The last time they became this bullish, Treasuries rallied (despite extreme public bearishness).
As my colleague Michael Lebowitz showed last week, U.S. Treasury yields have been bumping up against a very important, long-term trendline that goes all the way back to the late-1980s. If Treasury yields can close above this line, it would be bullish for yields and bearish for Treasury bond prices, but if they can’t close above this line, it may lead to another decline in yields (and surge in Treasury bond prices).
Crude oil is worth watching closely in order to understand U.S. Treasury bond movements (crude oil and Treasury bond prices move inversely). WTI crude oil is sitting just under its $65 resistance level, which marked the highs in January and February. If crude oil fails to break above this resistance and falls back down, it would be bullish for Treasuries (and vice versa).
Brent crude oil is sitting just under its $70 resistance level:
As I’ve been showing, the “smart money” are even more bearish on WTI crude oil than they were in early-2014, before the oil crash. If the “smart money” are proven right and oil experiences another strong bearish move, it would be bullish for U.S. Treasuries.
The latest bout of weakness in the U.S. stock market has been helping to support U.S. Treasuries. Treasuries often benefit from the “flight to safety” effect when risk assets such as stocks sell-off. As the chart below shows, the SP500 is sitting just above an important uptrend line that started in early-2016. If the market sell-off continues and the SP500 breaks below this line in a decisive manner, it would be a worrisome sign for stocks, but a bullish sign for Treasuries. If the SP500 is able to stage a strong rally off this uptrend line, however, it would be bearish for Treasuries.
As usual, I will keep everyone updated on these charts and markets I’m watching.
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