High Yield from another angle

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High yield has been fair to overvalued for some time now and until recently continued its lofty ascent with few serious downdrafts. The I-Shares HYG ETF that represents a large portion of the high yield market began to crack in late June and then recovered into mid August where it began a serious decline as it is down 2.58% over the last month.

At times it is informative to look at other related markets to gauge overall health in a particular risk asset class. In this piece we will review Business Development Companies and how their performance may be indicative of risk appetite and the forward risk reward in credit.

To begin, we highlight the major characteristics this asset class possesses with a little history.

” In 1980, the U.S. Congress created a class of corporation called a business development company (BDC) to encourage the flow of public equity capital to private businesses. ” They likely did this in order to help facilitate the development of companies that were overlooked by larger lenders.

To qualify as a “regulated investment company,” a BDC must invest at least 70% of its assets in private or thinly traded, public U.S. corporations, and must distribute at least 90% of its taxable income to shareholders in the form of dividends.

BDCs must also make available significant managerial assistance to their client companies and make mostly short-term, unsecured loans in the $2 million to $50 million range. Also, they frequently take ownership positions (equity interest) in their client companies. Since they must pay out most of their profits to shareholders, BDCs must raise cash to fund expansion by selling more shares or via borrowing.
BDCs went through hard times in 2008 and early 2009 when the economy tumbled. Now, most have recovered, are financially strong, and well positioned to prosper if the economy continues to strengthen. ” Source-“Dividend detective”

As outlined above, BDCs invest in a very risky part of the capital markets that have the characteristics of high yield and private equity. These are both risky asset classes and a robust flow of credit is essential to both strategies.

The appeal for high yield and for BDCs is mainly the yield and the Fed induced reach for yield has many investors out on a risky limb. Let’s take a look at an I-Share representation of this asset class. The UBS ETRACS linked to the Wells Fargo Business Development Company Index(BDCS) represents finance companies that hold as their portfolio the debt and at times equity of the target companies. This is a solid business model in a growing economy where the BDCs can lend at low rates and earn the spread on the debt they own. If this relationship is threatened, losses can be immense as they were in 2008 when BDCs generally did much worse than the S&P500.

Over the last 3 months, this instrument has generated a return of negative 7% which is also about the timing of the slide in high yield debt. There are many factors at work in a complex system but we would like to provide some thoughts to help guide your next investment discussion on risk.

It is important to determine if we are entering a credit slowdown or a sharp deterioration in credit conditions. If those conditions are true, then both high yield and BDCs will likely do poorly. Also, if borrowing costs rise in the face of a faltering economy, it could be even worse.

We recommend that investors look past the 4.74% yield on the I-Share HYG and the 7% plus yield on the BDCS ETN and look to see if this is merely a risk off pull back or a sign from two markets that credit is going to become even more expensive.

Sincerely,

Tom Koehler-CIO

Interest rates. Long or short? Review and repost

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The post below is taken from our Sept 14, 2014 interest rate and Fed Funds rate increase historical perspective piece.  Given the current debate on the timing of a rate increase, we believe it would be helpful to take a look again at some historical evidence.

At this point, we view rate volatility to remain the risk as opposed to a major regime change where rates find a new much higher equilibrium. Over the next few months, we advise that your firm take advantage of volatility to add to high quality duration. Below is the past article.

Rate fears, rate reality and some history.   There is a lot of concern with regard to interest rates and the inevitable higher levels in most investors minds. We feel it is worthwhile to examine history with regard to interest rate increases and the effect on the overall yield curve or long rates specifically.   Short term and long term rates react differently to market dynamics and the “rates will rise” concern, while very legitimate needs to be dissected and assessed in a historical context. This will help advisors and investment committees sort through and adjust their portfolios given some potential scenarios.   According to a June 2014 Economics report by Credit Suisse, there have been four Federal Reserve tightening “cycles” of various sizes and durations over the past two decades.   (First Rate hike)                      Full Cycle

Starting Fed Funds Target Date Size basis pts Length in months Size in basis points Number of rate hikes Terminal Fund rate
3 Feb 94 25 13 300 7 6
5.25 March 97 25 1 25 1 5.5
4.75 June 99 25 12 175 6 6.5
1 June 04 25 25 425 17 5.25

*Source Credit Suisse from the Federal Reserve   “Fed tightening cycles were initiated at different times of various business cycles, against different economic and financial backdrops. But there are a few overarching themes common to all these episodes. 1. In general, the FOMC recognized the importance of fighting inflation before inflation was a problem. A long-term chart of inflation overlaid with initial Fed rate hikes suggests that the Fed had success in this endeavor. The challenge then, as now, was to balance the benefits of pre-emption with the costs of potentially tightening prematurely. 2. Each of the past four rate hike cycles began with a small, 25bp rate hike. Many of these cycles began after years without a tightening, and the FOMC assumed that the first rate hike after a long hiatus would have an over exaggerated effect. 3. In tightening cycles over the past 20 years, the FOMC took seriously its obligation to explain to the public why rate hikes were necessary, and the Committee took various steps to prepare the markets for tighter credit conditions.” *Source credit Suisse   It may be helpful to note that 10 yr rates rose prior to the initial tightening in 2004 and subsequently declined after the tightening. This may help as the thought that rates will “explode” upward at all points on the yield curve may be slightly misguided if history parallels. In part the decline is or may be due to the perception that the Fed has inflation under control. It may be once again that the market on the long end of the curve moves higher in yield in order to encourage the Fed to begin to raise rates to stave off potential inflation and to begin to drain the massive amount of excess liquidity from the system.   Charles Schwab’s Fixed Income Team recently compiled a piece with regard to this issue and feels that given Fed statements with regard to timing, we are looking at mid 2015 as the first of the Fed Funds Rate Hikes. Here are a couple key points.

    • Improving economic data hasn’t changed our estimate that the first Federal Reserve interest rate hike of this business cycle will occur in mid-2015.
    • As the Fed raises rates, we think the yield curve will flatten as yields increase on the short end of the curve.

That implies that investors should not completely abandon all duration as they seem to believe that longer term rates are reasonably anchored. We at Zenith also believe that longer rates may rise but not substantially and though there may be a bond bubble, it is not imminently going to burst. They cite some important statistics. “The economic data have not been consistently strong and inflation is holding near 2%. For example, much of the increase in the Q2 GDP estimate was due to a rise in inventories, which may suggest slower production as those inventories are drawn down. Also, housing activity has slowed substantially this year. Moreover, the majority of Fed officials are focused on unemployment. One measure they’re watching is the high level of “underemployment,” which includes those who are working part-time because they can’t find a full-time job, as well as those who are marginally attached to the workforce. Additionally, the number of people unemployed for over six months remains above 30%—high by historical standards.” They cite the important short-term/long-term rate dynamic similar to the work Credit Suisse provided on the subject. “We expect the yield curve to flatten as the first Fed rate increase of the cycle approaches, meaning that short-term yields will rise more than long-term yields. This was the pattern in the past three Fed rate hike cycles–in 1993-94, 1998-2000 and 2003-06. In each case, more than half of the increase in 10-year Treasury yields from the cycle trough to peak occurred before the first Fed rate hike, and then yields on the short end of the curve began to follow suit. It seems likely to us that if the Fed begins to raise short-term rates next year as indicated, a similar pattern will unfold, for three reasons. First, short-term interest rates are still near zero, where they have been for nearly five years. Meanwhile, long-term rates have already risen by nearly 100 basis points from the lows of last year. A basis point is one-hundredth of a percentage point. And with inflation at 2%, short-term rates are negative in real terms, while real long-term rates are at least positive. It appears to us that the process of “normalizing” interest rates has already begun for longer-term rates but not for short-term rates. Second, inflation and inflation expectations are relatively stable. While short-term interest rates are heavily influenced by Fed policy, long-term rates are influenced to a great extent by inflation expectations. Currently the indicators for inflation expectations that we follow, such as the implied inflation expectations in the TIPS market, suggest that expectations remain steady near 2%. Third, the yield curve is already quite steep by historical standards. Although the yield curve has flattened since the start of the year as long-term rates have fallen while short-to-intermediate term rates for two-year to five-year bonds have risen, the difference is still wide compared to the long-term average. Over the past ten years, the average difference has been 95 basis points. It currently stands at over 200 basis points.” We at Zenith understand the immense challenges for any fixed income investor and stand by ready to help you analyze and determine your current risk profile as a whole and by product. As mentioned in our previous segments to this series, there are overvaluations in the US and globally. We also believe that there are managers who are able to potentially mitigate some of this risk and also who may be able to uncover value. We hope you enjoyed this short piece on the rising rate question and welcome your thoughts, concerns or observations you have with regard to this issue. We will be back next week with some manager selection and insight for your consideration. Sincerely, Tom Koehler-CIO

Global Bonds-Where is the value?

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In our last piece we reviewed a few major concerns and attributes with regard to the US fixed income market. The major issues included inflation uncertainty, stretched valuations and overall low real yields.

We will now examine the global debt market landscape to aid advisors and investment committees in their quest to provide reasonable fixed income solutions in an environment that seems very unreasonable.

We begin our international journey by taking a look at the Treasury Bond Index outside of the US.

I-Shares International Treasury Bond ETF (IGOV)
S&P/Citigroup International Treasury Bond Index Ex-US ($)

This ETF holds a yield of .82% yield and a duration of 7.22 and this is to be expected with a 22% weight to Japan. Obviously, this fund tracks an index that possesses an antiquated market weight scheme.

This high duration has helped fuel the 7.65% plus rally in the last year in an otherwise anemic index that has not displayed signs of credit improvement overall. The deflation fears in Europe have helped drive this massive performance as the fundamental picture has not improved enough to warrant this significant performance. There has been and to some degree a hope that this deflationary fear will lead to massive liquidity on the part of the ECB, driving yields to even lower levels.

Some of the least fundamentally strong countries such as Greece have performed the best as this liquidity induced risk on trade has taken the lower credits and driven them in our estimation to long term unsustainable price levels.

According to Lazard, “The outlook on European fixed income is uncertain due to the diverging policy paths of the US Federal Reserve (the Fed) and the ECB. In the
United States, the Fed will most likely continue tapering its bond purchases and the rumors of a rate-hike in 2015 have not subsided. However, the ECB will continue its easy money policy for the foreseeable future.”

“The recovery in Europe remains uneven as the region gradually exits a recession. The European banking system is still in trouble and there has been no progress in the banking union discussion. Uncertainty exists for a number of reasons, including the ECB’s upcoming banking stress tests and the Russian/Ukrainian crisis, which could further dampen sentiment in the European economy. Against this backdrop, it is no surprise that the disinflationary trends in the European economy have accelerated in the last months to the point that there are concerns about deflation.”

“Regardless of how the Fed acts regarding US monetary policy, it is clear that the ECB wants to keep the short end of the yield curve well anchored. But, it is uncertain what
the combination of a tighter Fed policy and an even more accommodative ECB policy means for the European fixed-income market and the euro.”

Zenith feels that this uncertainty and the real possibility of divergent gains moving forward in European Sovereign debt markets, warrants an active manager as opposed to a passive ETF that lacks the nimbleness needed to navigate these areas.

Lazard “expects European core government bonds to continue to trade in the relatively tight range established in the last quarters with the biggest risk a bond bear market in the US.”

Looking forward, “Lazard expects sentiment about spread products to remain positive in third quarter of 2014. The majority of lower-rated spread products are still more attractively valued compared to the extremely low-yielding money market products, core European government bonds, and highly rated covered and corporate bonds. However, we expect the market to become tougher on these relatively low spread levels. We expect the strategic shift from core European bonds into the European periphery and various lower-rated spread products to continue to be a major investment theme. This shift may be enough to earn the carry of the spread products and allow for moderate tightening. In general, we remain overweight to lower-rated, high-beta spread products. However, due to the risk posed by US monetary policy, we plan to remain short in duration, but stay flexible to change course quickly, if necessary, as sentiment can abruptly sour. Recently, there have been signals of over-optimism in the global fixed-income markets, as seen by the deterioration of bond covenants, the printing of ultra-long (100-year maturity) bonds, and the oversubscription of almost all new issues. In addition, despite the return of geopolitical risk in the last quarter, due to the events in Ukraine, Iraq, and Syria, all global risk indicators have fallen to very low levels. Because of this over-optimism, we expect some volatility in the months ahead, at least until the focus on risks returns. As active asset managers, we plan to take advantage of the anticipated turbulence to make tactical asset allocation and market-timing decisions.

In its 2014 Outlook for Financial Markets, Swiss Life Asset Management states, “The meeting of central bankers in Jackson Hole has confirmed our previous view of diverging monetary policies. Hence, we expect the Bank of England and Fed to start hiking in 2015 and the ECB and Bank of Japan to stay accommodative.”

This appears to us to be a bond world that is not necessarily going to be rising in unison as we move forward in 2014 and into 2015. Once again we would like to emphasize the importance in this uncertain policy world to have a manager that is able to analyze the macro landscape as well as the micro credit work.

While the healthy returns could continue, we believe it will take a nimble and adept manager to be able to sort through the risks and potential rewards.

I-Shares USG Emerging Markets (EMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.25% yield and a duration of 7 which has helped it gain over 13% over the last year. The dollar denomination also helped as did a rebound in most Emerging Market risk assets.

I-Shares Emerging Market Local Currency ETF (LEMB)
J.P. Morgan EMBI Global Core Index

This ETF holds a 4.91% yield and a duration of 4.25 and this after a nice 10% plus return over the last year.

Given two ETFs with the exact opposite currency mandate, it becomes difficult to choose unless an investor has the time and infrastructure. to be able to make currency calls. We believe it is more prudent to seek an active manager who can chose the best securities in both worlds.

The outlook for the emerging world is likely to be mixed as there are many countries with varied policies that will affect real rates, inflation expectations as well as credit conditions.

Research Affiliates Shane Shepard delves into the Emerging Market bond space to explain the areas that they find opportunities within fixed income in their latest piece dated July 2014.

“Emerging market sovereign bonds that are issued in local currencies are supported by high real yields and improving credit quality. In addition, their risk-to-reward profile is enhanced by declining currency volatility and a positive long-term outlook for currency appreciation.”

• High real yields-The short- and medium-term “risk-free” government bond rates for the G-5 countries all currently reside in negative territory (see Figure 1). In developed markets, the right to a certain return of capital is actually costing anywhere from –1.5% to –0.5% per year in real purchasing power. On the other hand, real yields in many of the larger emerging market economies reside solidly in positive territory—returning anywhere from about a 1% premium over inflation in Mexico and Russia to more than 6% in the case of Brazil.

• The historical spread for the J.P. Morgan GBI-EM Global Index is just under 7% as the difference between the index yield and the short-term U.S. Treasury rate lies well above its long-term average of 5.2%. But, most strikingly, this spread has rebounded (due to the well-documented “taper tantrum” of 2013) to levels just a touch below its all-time high during the 2008 global financial crisis!

• Currency Appreciation-The volatility of local currencies is undeniably substantial; the currency risk swamps the volatility of the underlying bonds. Nonetheless, the currency exposures may provide an incremental boost to long-run expected return. Because of the differences in productivity growth, in the long run we expect emerging market currencies to appreciate relative to the U.S. dollar and other major developed world currencies.

• Currency volatility-At least for the past five years, a basket of emerging market currencies has contributed no more volatility to an international portfolio than a basket of developed currencies. And as emerging markets continue to do just that—emerge—the convergence of currency risks may be expected to continue.

• Credit quality-The fourth factor is the strengthening credit quality of emerging market bonds. 15 years ago only a handful of countries were in a position to issue local currency debt, and their average credit rating was BBB+. Now many more countries participate in the local currency debt market, and the average credit rating is closer to A–.

There is an interesting dynamic at play in the emerging market debt arena especially after the rate hikes by many of the countries attempting to bolster their currency. The rate hikes have, depending on the basket allowed for a 500 basis point advantage over US Treasuries.

According to Lazard, “Local emerging markets debt has been the bogeyman of the broad asset class for the past three-and-a-half years. Over this period, the local currency index, including spot currency rate changes, carry, and bond moves, has underperformed the dollar-denominated debt index by a whopping 19.1% on a cumulative basis and 4.80% on an annualized basis. The drivers of local market debt’s underperformance have been myriad; however, the key negative factors have been (a) an overvalued starting
point, (b) deteriorating fundamentals that affect local debt, (c) less correlation and duration of local debt to falling US Treasury yields, and (d) a moribund global economy. It is our view that all four factors that have pressured emerging local market returns over the last several years are in the process of turning, and will likely result in local market debt outperforming every part of the emerging markets debt asset class in the second half of 2014 and into 2015. We elaborate on these four factors here: First, emerging markets debt has had one of the greatest bull runs of any asset class from 2003 to 2010. Even including the early years of the financial crisis, external debt returned 10.6% on an annualized basis, while local debt returned 13.6%. Notably, the spot currency portion of local currency debt returned just 2.7%, annualized, over this period, while the carry and yield compression returned over 10%, annualized. By the end of 2010, most emerging markets currency valuations were trading richly to their historic real exchange rate averages, while the real yield differential between emerging markets and the United States had compressed to approximately 2%.

Strategically they are looking for the US Ten Year Treasury to return to its 3% Jan trading level and “this ought to weigh on assets with high correlations to Treasuries, such as global investment-grade and emerging markets hard currency bonds, and favor shorter-duration, more idiosyncratic markets, such as emerging markets local debt.
In summary, while we maintain our defensive stance across emerging markets due to stretched valuations, we certainly plan to add local debt in the second
half of the year to all our multi-asset class portfolios. The key triggers to make that asset allocation decision are an improving US economy that leads to a
deteriorating US current account balance and more attractive entry points following what we expect to be a weak summer for fixed income asset”

This is a very difficult time for investment firms that have to allocate a certain percentage to fixed income and bonds in general. Here is a brief summary with regard to the challenges ahead that will lay the groundwork for our next piece that will have potential solutions.

• US valuations on most debt classes are stretched and spreads are tight by most measures and historical norms.
• European sovereign debt has performed tremendously in spite of weak fundamentals and leaves investors with a diminishing opportunity set.
• Emerging market debt offers real yields higher than their comparable developed market counterparts but also introduce currency risk and uncertainty.
• Central bank uncertainty and direction are causing potentially disastrous imbalances in the rate and currency markets.

In our next piece we will highlight a couple managers who have managed to navigate their area of the debt markets successfully and who have a reasonable mandate to be able to do so in the future.

Sincerely,

Tom Koehler-CIO

Bond Market Uncertainty

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Bond Market Assessment-Domestic Part #1

In our last piece we identified a few major concerns with regard to the fixed income market. The major issues include low global real interest rates, inflation uncertainty and overall potential overvaluation.

This has major implications for fixed income investors and especially for financial professionals who are in a difficult position as they need to allocate to an arguably expensive asset class.

As an example, a firm that has as part of its internal investment policy statement, a certain percentage allocated to fixed income is faced with a dilemma when a new client brings in new money.

Assume for a moment that a client arrives with $1,000,000 and they are deemed to be a conservative investor. For the hypothetical firm in question, that could mean that a conservative investor is allocated 50% to fixed income. This is for illustrative purposes and of course that can depend on each firm’s definition of conservative and the amount of alternative strategies within the portfolio that may reduce to some degree the fixed income allocation. For a million dollar portfolio, $500,000 needs to find a home in a tough asset class.

We will examine various US bond indexes mainly through ETFs that represent them to frame the issue more thoroughly.

I-Shares Barclays Aggregate (AGG)
Barclays US Aggregate Index

This fund possesses a 1.96% yield with a duration of 5.19 and an overall investment grade credit quality.

This product has produced approximately a 5.30% one year return in part due to the strong bid in the treasury market along with reasonable returns from Mortgage Backed bonds. Our concern is that there is major duration risk in this product. The investment grade rating does provide some comfort with regard to credit risk although it also limits the opportunity set.

Treasury Notes comprise 37% of the portfolio and have the potential to rally even from these low levels if deflation becomes a concern or if geopolitical issues do not resolve themselves. The real yield is not positive along a significant portion of the treasury yield curve and this means there is little value in this area. The negative real yields, though unappealing are still higher than their European counterparts as those yields have been driven even lower due in part to deflation concerns.

While there are always two sides to the valuation debate on any asset class, it might be worth noting an observation by Pimco’s Bill Gross in a recent article.

“Treasury yields are perhaps 150 basis points or 1½% too low when viewed on a historical context and when compared with expected nominal GDP growth of 5%. This conclusion can be validated with numerous examples: (1) 10-year Treasury yields, while volatile, typically mimic nominal GDP growth and by that standard are 150 basis points too low, (2) real 5-year Treasury interest rates over a century’s time have averaged 1½% and now rest at a negative 0.15%! (3) Fed funds policy rates for the past 40 years have averaged 75 basis points less than nominal GDP and now rest at 475 basis points under that historical waterline.”

Mortgage Backed Securities(MBS) comprise 28.5% of this fund and this asset class has benefited from the QE program as well as its favorable credit and interest rate profile. It has returned about 5% over the last year. While it has been feared that MBS rates would rise in conjunction with Fed Tapering, the coincidental reduction in supply of new mortgages has placed at least for now a floor under MBS debt. They also possess a superior risk to reward to Treasuries at least in the Agency space. An investor simply has a better interest rate to duration ratio. The I-Shares MBB that represents the agency mortgage backed market has a yield of 2.02% with a duration of 4. This is slightly better than Treasuries but not necessarily a powerfully positive risk to reward.

Prepayment Speeds have been a major factor in the decrease in mortgage backed supply according to Double Line headed by Jeffrey Gundlach. They go on to state, “We believe that these slower prepayment speeds are emblematic of an economy where the consumer is over levered and unable to behave in a fashion that would create greater economic strength. Whereas a decrease in mortgage rates should bring about an increase in prepayments, this increase should be less than what would normally be expected due to conditions that exist in the mortgage market today. It would take a major adjustment in underwriting standards and/or an improvement in nationwide incomes for this situation to change and we do not expect any major changes anytime in the near future.”

Prudential seems to share this view that the current environment may not posses the fuel needed to change significantly at least in the near term. While many are waiting for an inevitable rise in interest rates, Prudential believes that there will be continued moderate growth along with moderate inflation and that the “natural” state of the 10-yr Treasury Note is around 3%. This has been a level associated with a lot of institutional buying. Also, an anchor to US yields are even lower Japanese and Bund yields.

While Mr. Gross may be correct in his assessment that yields on Treasury products are over valued, Prudential is counting on more of the same. They state; “Against this backdrop of modest growth, moderate inflation, and low money market rates we believe that the ongoing search for yield will remain the overarching theme in the bond market.
We see this search not only keeping long term rates low, but also pushing credit spreads narrower, and thereby fueling outperformance by the non-government fixed income sectors, such as long term investment grade corporates, high yield corporates, structured products, and emerging markets debt. While returns will generally be lower in the years ahead than they’ve been in the decades past, over the long term, we believe most fixed income sectors are still likely to post positive returns, with the highest returns likely to be recorded by the aforementioned higher yielding sectors.”

This is interesting from two view points. The first is the explicit outlook that Treasuries will underperform spread sectors and the implicit outlook that Treasuries themselves are not vastly overvalued. That is in a stable environment as a return to 3% is about a 25% move which is significant. Geopolitical concerns are aiding in the restraint on the part of Treasuries to move back to that level.

This reasonably benign scenario is based in larger part on an expanding economy with low inflation. A disruption in the credit markets would likely cause spreads to widen and depending on the severity of the issue, could cause a significant loss of principal.

Investment Grade Corporate bonds with an Industrial emphasis comprise 22.7% of AGG. The investment grade sector as represented by the I-Share LQD has produced a one year return of 10% and has a yield of 3.03% with a duration of 7. Improving fundamentals and spreads above treasuries that have compressed have helped propel this return as well as its duration measure.

The Credit Report by Morgan Stanley dated July 23rd, 2014 holds some insight with regard to the credit markets and specifically investment grade debt.

“Investment grade (IG) credit has been remarkably stable over the last month and we expect this range bound pattern will persist, barring a sudden rise in interest rates. However, at current spread levels investors have little cushion to offset the negative effect of rising rates which will eat into total returns.”

According to Loomis Sayles, Option-adjusted spreads on all three investment grade indices continued to make multi-year lows throughout the quarter. Taking credit risk was rewarded as lower-rated BBB corporate debt outperformed higher-quality bonds in the US, Europe and UK. With declining global yields, longer-duration US and European bonds produced the strongest returns. In the US, corporate bonds rated BBB had the highest duration and posted the highest total return.

This is important as they are basically saying that while credit fundamentals remain in place, spreads have tightened to levels that leave little room for error. They have benefited from a long duration profile and a move up in quality from high yield. It will be difficult to repeat this strong of a performance in the future.

At this juncture, we would like to review the three major debt class that are part of the Barclays US Aggregate and its ETF(AGG). Treasuries, mortgage backed debt and investment grade corporate bonds. As mentioned above, they have all performed well and hold various potential in the future.

Spreads

While spreads on US corporate debt, AA and BBB are at or near their 52 week low according to the Wall St Journal on line. Current annual inflation is 2% leaving investment grade credit a relatively attractive debt class v Treasuries in some maturity segments. The Bloomberg US Corporate Bond Index effectively yields 2.87% or only .87% on a real inflation adjusted basis. The 10yr Treasury yields 2.42% or .42% on a real or inflation adjusted basis.

The margin for gain is very slim indeed. So slim that an otherwise overvalued high yield sector continues to garner attention as the Bloomberg Aggregate High Yield Index yields 5.65% or 3.65% on a real inflation adjusted basis.

Mortgage Backed Option adjusted Spreads are tight as well while not as tight as investment grade debt and on aggregate possesses a similar yield to the IG index with less duration risk.

This is a very difficult time for advisors who are attempting to build a fixed income allocation while real yields domestically are very low in many areas and so it is worthwhile to take a look at corporate fundamentals.

Back in June, RBS weighed in on the state of the corporate debt market with this commentary. While not calling for an implosion, they are decidedly against duration risk and concludes gains may be muted in spite of the reach for yield technical phenomenon.
“The need for “reliable” risk-adjusted yield will remain a dominant theme for credit investors in the second half of 2014, reflecting the realities of the current economic, valuations and monetary policy environment. We believe the IG and HY asset classes are now fully valued to their fundamental metrics, but the strength of technical conditions could push spreads tighter still. Year-to-date, corporate credit’s total return performance has far exceeded our original forecasts, due in large part to a hefty contribution from the rally in Treasuries; in the second half of 2014, we believe the pace of total return accumulation will slow and possibly reverse as spreads struggle for traction amid compressed risk-free rates and as Treasury yields gradually back up.
We expect the Fed to conclude its asset purchase program by October and to ratchet up its efforts to prepare the financial markets for the eventual tightening, most likely in the second or third quarters of 2015. The policy normalization phase could be bumpy, as the eventual hike in base rates shakes market participants of their collective low volatility stupor. In the meantime, we believe High Yield will continue to provide a better risk-reward trade-off than Investment Grade, courtesy of its lower duration, higher carry and muted default risk.” Source Barrons June 27th 2014

Northern Trust in March of this year within their fixed income outlook stated, “we believe that fundamentals remain in tact, It’s also worth noting that U.S. corporations are in excellent condition, having used the low interest rate environment of the past few years to refinance their balance sheets cheaply. They’ve been reluctant to invest in their businesses, despite access to cheap money and willing investors in the capital markets. The lack of desire to invest is perhaps most clearly seen in the record amount of cash sitting on their balance sheets. All of these factors, combined, lead Northern Trust’s fixed income team to believe investors will continue to find corporate bonds attractive.”

Slightly more cautious is the credit driven investment house Loomis Sayles. Their overall assessment is as follows; “The US is in the late expansion phase of the credit cycle,
which could continue for some time as fundamental and technical factors provide support to the credit markets. At current levels, credit valuations are stretched. As a result, we have modestly reduced risk and raised reserves as we wait for buying opportunities. As always, we remain focused on issue selection”

At Zenith, we have examined a number of themes with regard to the domestic credit markets and would like to summarize the current state.

A. Treasury securities have rallied significantly this year driving returns in the over all broad market as they and most any duration asset has done well. This has been in part due to the geopolitical risks, reasonable inflation and a yield advantage over the European and Japanese Bond markets.

B. Mortgage Backed Debt similar to Treasuries have rallied in spite of the imminent end of QE in October as high quality assets with duration have done well. At this point, we feel that these have a relative risk to reward advantage over Treasuries.

C. Investment Grade Bonds which are also a significant portion of the Barclays Aggregate Index have rallied especially those with a longer duration. Spreads have tightened significantly and leave little room for error in either a credit or duration shock.

D. High Yield Debt which is not a part of the Barclays US Aggregate Index have rallied as well and have very low option adjusted spreads. Since they have a lower duration than the IG universe, it has gained mostly on stable fundamentals, low default rates and a continued search for yield.

In sum, if rates and spreads remain stable, fixed income investors will continue to earn the “carry” until that time when fundamentals, inflation or both deteriorate. Before we recommend a few manager solutions to help navigate this new world for you, we will examine the global debt market-ex US to help shape the discussion for potential placements.

Sincerely,

Tom Koehler-CIO