10-12% Yield-Is it worth the risk?

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10/30/13

 Zenith Portfolio Strategies-12%-14% yield on Mortgage REITS

           We cited a tail risk with regard to mREITS  on our blog Oct 8th specifically with respect to the repo financing market. Here is the basic structure of an mREIT and a few more considerations before reaching for yield.

            An equity REIT actually buys the property or a real asset while a mortgage REIT buys Residential(RMBS) and Commercial mortgages(CMBS). They are buying bonds that are interest rate sensitive.

 Characteristics

  • They borrow short term via the repurchase agreement market(REPO) at rates that are currently very low due to the Fed anchoring short term rates near zero.
  • They use the borrowed funds(debt) to buy mortgage backed securities(debt) paying higher rates than the borrowed funds.
  • These are the mREITS assets.
  • This industry is currently structured in large part on funding costs(leverage) as low as they can go in order to buy (debt) whose interest rate sensitivity is very high due to low long term rates.
  • They earn the spread on this maneuver between short and long term rates.
  • They lose money when those bonds go down in value and gain when they go up in value.
  • They can hedge their book against a rise in rates but that is a cost that eats away at the spread they earn and can eliminate gains if rates go down so they need to be very, very adept at interest rate hedging.
  • This can be profitable in an increasing interest rate environment if they can hedge in a timely manner and then lift the hedge to participate in the larger spread due to new bonds having higher yields.
  • It can be a disaster if they do not hedge properly and they take a hit to book value and dividends need to be cut.
  • This disaster can be amplified if short term rates rise, increasing their funding costs and straining the REPO market that will be looking for their collateral.
  • In addition, these bonds in the RMBS and CMBS markets have credit risk as well.
  • For this investment to work out with a reasonable degree of confidence going forward a few pieces need to come into alignment.
  • The Federal Reserve needs to leave the Fed Funds rate low
  • Intermediate and long term rates need to remain stable over the foreseeable future.(May and June were not stable)
  • The mREITS need to have very capable hedging operations and solid mortgage backed credit and interest rate assessment teams.
  • REPO rates need to remain low and that market needs continued liquidity

            This is a very appealing yield that comes with a LOT of risk that can increase exponentially if the yield curve “cracks” and these mREITS are running for cover just to post collateral to their REPO desks.  

            Two ETFs in this space are down 24% and 21% from their highs this year back in Spring before the Fed shocked the yield curve by talking of Tapering asset purchases, driving the 10-yr Treasury significantly higher. That may be an appealing entry point although another yield shock would present a better one.

            We recommend a placement in this area only as a tactical placement especially if you utilize an ETF as there will a day that the favorable dynamics that have helped this sector deteriorate. While some are banking on a Fed Funds rate low until 2015, a stronger economy could potential raise that borrowing cost and an inflation surprise along with a Fed taper could send long rates much higher.

            Lastly, this position needs to be monitored as it is not a strategic long term holding for most investors as the risks are simply too high and too uncertain.

            In additional posts we will delve into the instruments available in this space and the ones we feel warrant the most attention from your investment committee.

Sincerely,

 Tom Koehler, CIO

 

 

Emerging Market Debt

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A significant amount of investors bond portfolios are US centric and while there is a robust opportunity set within the domestic sphere, there are drawbacks to holding a 100% US bond portfolio. In this piece we would like to address those issues and to introduce Emerging Market debt(EM), it’s characteristics and a present rationale for an active vs. passive approach.

Drawbacks

The main drawback is that the US Bond portfolio is dollar denominated and while this can be advantageous during times of dollar strength, it does not allow for currency appreciation in other currencies such as the Brazilian real or the Turkish lira for instance.

The second drawback is the limited opportunity set. The US Treasury Bond market does always warrant consideration for investment although the Indonesian Government Bond Market and the Polish Bond Market may deserve investment dollars. If the US High yield market is overvalued, perhaps an examination of High Yield Debt in Latin America would result in a favorable credit investment opportunity.

A third drawback is domestic only diversification. While there are diversification benefits within US debt classes, a more robust opportunity set that includes Emerging Market Debt may allow for additional diversification and avoid over concentration in any one US debt class.

While we believe that Emerging Market Bonds offer potential for a portfolio to help to mitigate some of the drawbacks of a US centric portfolio, we feel it is important to examine the segments of risk and reward.

Main risk and reward areas for EM bonds.

• Credit quality-The sovereign or corporate debt credit rating can increase or decrease the value of a bond based on the issuers ability to pay. This has been a significant tailwind for a number of years as many countries aided by strong EM growth and reasonably well run fiscal and monetary policies have seen the value of their debt appreciate considerably. There are bond appreciation opportunities due to credit upgrades but it may not be as powerful of a tailwind as in the past. Approximately 75% of the EM universe is investment grade so managers will need to look at a larger opportunity set to find credit upgrade potential.

• Duration(interest rate sensitivity)-This has helped a lot of the early participants in the EM debt class maturation process and can be a significant portion of the returns going forward but much more selectively. The emerging market debt indexes have to be dissected and expanded upon in order to continue to have interest rate sensitivity work in the investors favor. While difficult to quantify, we favor managers who are able to delve into the macro picture and invest where there are true “real rates” available. This sounds simple but measuring and gauging future rates of inflation globally is no easy task. Once they find solid real rates of return, the anticipation of course is for overall rates to decline so the bond can appreciate in value.

real rate=nominal rate-inflation

• Currency-This is arguably the most complex portion of this opportunity set. It is subject to supply and demand, interest rates, inflation and perceived monetary policy action in the future. It is also one of the areas that offers the most diversification and return potential and when invested in conjunction with credit and duration can be quite appealing but volatile.

The first portion of this piece focused on the drawbacks of a US only bond portfolio as well as an overview of the main segments of risk and reward within emerging market debt. Next we will compare a broad based US ETF with a couple broad based Emerging Market Exchange Traded Funds(ETFs)

US vs. EM Bond ETFs

I-Shares Core Total US Bond Market-AGG While this indicates that it represents the total bond market, it has a heavy weight in Treasuries and Mortgage Backed Debt. Here are the main characteristics.
• US Investment Grade Bonds
• “A” credit rating overall
• 30 Day SEC yield is 2.20%
• Duration 4.93 yrs
• Treasuries and Mortgage Backed Debt represents over 60% of the index.

While at times there has been merit to owning this instrument, the fact that there is currently around $14billion in assets with this fund is very disconcerting given its current characteristics.

Replacing this with domestic bond managers who specialize in various sectors of the bond market makes sense to garner higher risk adjusted returns and to move out of a treasury based index. We will cover that in another piece but for now will highlight two funds that cover a broad EM Debt market.

I-Shares J.P. Morgan USD Emerging Markets Bond ETF-EMB
• US dollar denominated emerging market debt
• Sovereign bond focus
• “bb” credit rating
• 30 Day SEC yield is 4.96%
• Duration 7.11 yrs
• Reasonably well balanced among the countries represented.

While an investment into this ETF garners a higher yield, it comes with added duration and credit risk as well as an investment denominated in dollars. Also, it is focused mainly on sovereign bonds which leaves out corporate debt. Lastly, the return and diversification benefits due to active currency selection is not available with this fund. It holds approximately $3.6billion in assets which is also disconcerting given the narrow focus in a segment that requires nimbleness. Unless an investor has a high conviction view with respect to $ denominated EM Sovereign Debt, we highly recommend avoiding this product and to sell it and to seek a better instrument.

I-Shares Emerging Markets Local Currency Bond ETF-LEMB
• Non-US dollar denominated emerging market debt
• “bbb” credit rating
• 30 Day SEC yield is 4.90%
• Duration 4.02 yrs
• South Korea and Brazil represent about 30% of the index.
• $611million in assets

Here are the main risks with both these ETFs and with a passive investment into EM Debt in general as we view it at Zenith.

• In the first ETF(EMB) the investor is stuck in dollars and in the second ETF(LEMB), they are stuck outside of dollars. Even if the goal is to be out of dollars with a portion of risk in a portfolio, lack of active selection leaves the investor vulnerable to the current currency weights in the passive basket.
• Credit risk is higher in both and given the complexities of credit research, we would prefer a team that has the time and experience to find value across credit upgrade opportunities as well as overvaluation in downgrade scenarios.
• EM Sovereign debt performance can fall out of favor at the same time that EM investment grade bonds and EM high yield bonds perform well and if they are not part of the underlying basket then that potential is lost.

We acknowledge that they do offer two additional products that represent corporate investment grade and high yield within the emerging market space offering the investor a way to extend beyond the products listed above. Here is the problem. How many investors have the time or resources to actually develop a conviction view on Emerging Market High Yield Debt? We would argue only an advisor who has the time to develop that view should be utilizing this product and then only tactically around a strategic holding with an active manager.

The emerging market debt space is much too dynamic and complex to use an ETF other than for potential tactical purposes and only if you have keen insight into any one of the four mentioned classes. Our rationale is based on the fact that the opportunity set that includes $ and non-$ government debt as well as corporate debt is too disparate to leave to passive management. Even if an ETF were to come out that attempted to gain exposure to the entire opportunity set, would you want passive exposure to Brazilian Industrial Bond exposure coupled with Turkish Government bond?

There are additional ETFs that represent various segments of the EM bond market and all possess their positive aspects as well as their negative ones. While there can be a place for them tactically with a solid understanding of the risk/reward proposition, we believe that an active manager is the best solution to this asset class.

With that in mind, our screens came up with a short list of managers that we feel can add value over a passive ETF. The general qualitative characteristics in an emerging market fund manager include but are not limited to:

• thorough macro economic insight
• defined country and currency selection process
• flexible mandate in order to be able to buy $ or non-dollar debt
• open to a very wide and somewhat unconventional opportunity set
• the past or strong future ability to beat a passive investment
• yields higher than the index with less duration risk

This piece looked specifically at EM Debt which can be a rewarding space to invest although there remains issues of a potential risk-off environment, a global slowdown that hurts EM countries financial ratios and less real rates available over time.

Tom Koehler-CIO

“Emerging Market Debt represents a complex asset class and while we covered a reasonable amount, there is a lot more information needed prior to making an investment decision. Let us know if we can provide more information to help in that process.”

High Yield Brief

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Zenith Portfolio Strategies High Yield Brief

This may help frame the discussion for your next investment committee meeting as you determine the appropriateness of high yield debt in your portfolio.

Pros

• Low default rate is projected to continue as issuers have taken advantage of low yields to refinance and to extend maturity. 75% of the Credit Suisse HY Index bonds come due in 2017-2021.
• The Fed Taper numbers for employment and inflation do not warrant an immediate reduction of asset purchases and they have guided that short term rates should be low into mid-2015.
• High Yield has held up well and is positive for the year as credit has generally done better than the Treasury heavy Barclays Aggregate Index
• High Yield has a yield of about 6%.
• Reasonably strong corporate fundamentals support continued issuer payments.

Cons

• Corporate fundamentals can deteriorate quite rapidly, pressuring high yield bonds.
• The wall of maturities will become an issue in a couple years.
• The “perfect storm” can develop if the fundamentals deteriorate at the same time as maturities become imminent.
• At that point, instead of market price risk and volatility, the investor is faced with the real possibility of an increase in defaults.
• Bonds of companies that are perceived to be heading toward default trade at prices much lower than they enjoy while default risk is pushed into the future.
• The aggregate price of the high yield universe is higher than the historical average of 92 cents on the dollar hovering around par or above.

We feel that this asset class has benefited from a number of factors including the low rate environment that has helped the corporations and forced a lot of investors into higher yielding securities as a reach for income.

While high yield is not likely to implode, this asset is at best reasonably valued and in most cases richly priced. However, there are pockets of this market that continue to offer value and we recommend utilizing a mutual fund vs. an ETF for a few reasons.

We look for a manager that possesses a defined strategy compared to a passive approach.

I-Shares i-Boxx $ High Yield Corporate Bond ETF HYG-

This ETF will provide passive exposure to this asset class at a reasonable fee and will mirror the overall high yield market decently although we prefer to have the main risks and opportunities in below investment grade debt managed.

Our manager search given our criteria yielded two managers with one or all of these characteristics.

 volatility that is less than the ETF listed above
 less decline during the May/June sell-off than HYG
 lower aggregate price of the portfolio compared to most high yield indexes
 higher yield
 greater alpha producing system such as through substantial credit research
 duration management

We recommend that you take the time to vet your current high yield exposure and to re familiarize your teams insight into your managers defined strategy. Also, if your current exposure is with an ETF, consider a manager with superior metrics and who has a plan when the credit conditions are not so good.

Sincerely,

Tom Koehler-CIO

Market risk- the talked about and the tail

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1. Debt ceiling-VERY talked about. The fallout of not raising it is not completely certain as I mentioned in my last blog.

2. Taper-EXTREMELY TALKED ABOUT -This is discussed so much that it would normally cease to be important but 85billion/month in security purchases is very important.  There is a potential slowing of purchases, the potential end of purchases and when OR even the expansion should economic numbers disappoint.  We disagree with Bill Gross who is mainly focused on the Fed Funds rate. The shape of the yield curve and the implications for mortgage rates, banks earnings and housing is very important and the amount and direction of QE/Taper will hurt or help the financial markets.

3. Mortgage REITS funding via REPO- This is a TAIL as it is not on the radar screen of many firms-Here is the excerpt from Market Watch-

Looking at the big picture, there’s concern among officials about the possible systemic risk posed by mortgage REITs and other entities that use repo markets for short-term funding. A new financial-stability report from the International Monetary Fund cited vulnerability to risks from rising and volatile rates if collateral is liquidated, leading to fire sales and funding interruptions, among other problems.

“Given that the repo funding of the two largest mREITs is comparable to Lehman Brothers’ precrisis repo book, at the very least the mREITs point to a microcosm of fragilities in the shadow banking system that deserve closer monitoring,” according to the IMF.

A separate report from U.S. regulators reported similar findings, according to the Financial Stability Oversight Council, a federal watchdog created by the Dodd-Frank bank-reform bill.

“A shock to agency REITs could induce repo lenders to raise margins or pull back funding, which in turn could compel agency REITs to sell into a declining market, potentially impacting MBS valuations significantly,” the FSOC’s report says.

It is worth at least a discussion at your next investment committee meeting.

Tom Koehler-CIO

The Debt Ceiling and Default

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This short summary by Moody’s help place the current debate into logistical context.

  • “There is no direct connection between the debt limit and a default,” says Moody’s Steven Hess, believing the government would continue to service its borrowings even if the debt ceiling isn’t raised by the Oct. 17 deadline. The debt limit, he notes, restricts government expenditures to the amount of incoming revenues – it does not prohibit servicing existing debt or issuing new paper to replace maturing debt.
  • Interest could be a different story, and technically is an expense the Treasury could decide not to pay. Even still, the first interest payment isn’t due until October 31, and it’s a relatively small $5.9B. Mid-November’s payment is $30.9B.

We still believe that if it is not raised at least initially risk premiums across credit products might widen and possibly with less net debt, there could be a bid for Treasuries and Mortgage Backed Securities as the Fed would be buying the same amount of a lesser total since they decided not to taper.

Tom Koehler