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

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