Quarterly Market Update
Fixed Income Outlook
Investor Complacency and Yield Grab Drive Bond Markets.
Whether driven by complacency or the absence of attractive alternatives, investors may be growing too comfortable with low Treasury yields and tight credit spreads.
To the surprise of investors, the fixed income market continued to defy rumors of its imminent demise as it rallied in the second quarter amid the disappointment of many retirees living on bond portfolios long wrung virtually dry of any appreciable income stream. After closing at 3.03% at the end of 2013, the yield on the 10-year U.S. Treasury fell to the year-to-date low of 2.45% before ending the second quarter at 2.53%. The collapse in bond yields was driven by revised first quarter GDP growth of -2.9% coupled with unsettling geopolitical events in the Ukraine and Iraq. The ECB’s continued interest rate cuts and commencement of large-scale bond purchases just as the Fed is retreating from similar policies also contributed to the rally in U.S. bond prices. Declining yields on some European sovereign debt with credit ratings below that of U.S. Treasury debt acted to suppress U.S. Treasury yields because, from a relative value credit quality perspective, domestic debt is still attractive compared to that of developed Europe and many other countries.
The Fed continues to reduce purchases of U.S. Treasury and Agency debt by $10 billion at each FOMC meeting and is on track to exit the quantitative easing program entirely in October with the first increase in the federal funds rate slated for the second half of 2015. The consensus estimate of the 16 FOMC members for the fed funds rate over a normal cycle (i.e., five to eight years) declined from 4.0% to 3.75%. On average, the fed funds rate has historically been targeted around 5.0%, so a lower target indicates that the Fed does not believe that the economy will be as strong as originally thought, requiring an easier money stance in order to reach healthy, sustainable GDP growth of 3% or higher.
Figure 1. Corporate bonds outperformed U.S. Treasury, U.S. Agencies and Municipals for the quarter and year-to-date.
Corporate Spreads Tighten Despite Increased Issuance
Complacency with bond market dynamics and the continued reach for yield led to corporate yield spread compression on the front and back end of the yield curve. Despite new issue volume exceeding the average by roughly $35 billion per week, with only a brief respite surrounding Memorial Day, spreads remained tight or even tightened further for lower quality credits.
A look at high yield credits illustrates the point. According to Bloomberg, aggregate credit spreads on BB- rated corporates tightened approximately 80 basis points during the month of June, to +250 from +330. Likewise, B-rated corporates tightened to +350 from +440, a 90 basis point move tighter. CCC spreads closed out June at +640 after starting at +790, tightening 150 basis points. Currently, these credit spreads are the tightest measured since mid- 2007, just before the most recent credit crisis. Combining those tight spreads with the low U.S. Treasury rate environment, we have the lowest yields ever recorded in the high-yield sector of the corporate market.
Figure 2. Complacency with bond market dynamics and the continued reach for yield drove corporate yield spread compression on the front and back end of the curve.
Agency Yields Negative to Treasuries
Fannie Mae and Freddie Mac have not recently issued bonds with maturities longer than five years, but even in the one to five-year sector there was no incremental yield available for the additional risk assumed. In fact, Agency credit spreads in the two and three-year part of the curve were negative to Treasuries. Similarly, spreads on 15 and 30-year mortgage-backed securities are at their tightest level in 18 months.
Shrinking of the Overall Municipal Market Continues
Municipal bond performance is increasingly a function of supply and demand dynamics. Municipals continued to follow the direction of Treasuries, with modest outperformance based on the lack of municipal bond supply. Issuance so far in 2014 has been subdued, running about 10% below last year’s level although it picked up modestly late in the quarter. The decline puts the market on pace to contract for a fourth straight year as states and cities focus on cutting expenses and paying off old debt rather than borrowing for new projects.
Healthy investor appetite for tax-free income means that any deal that comes to market, especially on the A-rated and higher market, is easily absorbed. The market failed to sell off even when the governor of Puerto Rico signed a bill allowing some public corporations to possibly restructure their debt. In the continental U.S., credit quality has improved slowly along with the economy. For example, California, a big issuer and a significant part of the municipal index, was upgraded to AA3 at the beginning of the quarter from A1.
To one degree or another, every investment in the world is essentially priced off of the yield on the 10-year U.S. Treasury, and with rates being so low for so long, it has brought confusion to the valuation process.
Based on disappointing first quarter GDP and the situation in Iraq, we expect the 10-year U.S. Treasury yield to end the year at 3.0%, down from our previous projection of 3.25%. Overall bond dynamics beg the question of whether investors are getting paid for the level of risk they are assuming. Some pundits speculate that indeed every asset class is overvalued and that a global bubble is developing. But the issue is ultimately the low absolute interest rates and how those rates fit into expected return calculations. To one degree or another, all investments are essentially priced off of the 10-year U.S. Treasury yield, and it is something of a mystery as to how to determine overvaluation when the yield on the 10-Year Treasury remains so abnormally low.
Figure 3. State and municipal monthly bond issuance is down in 2014 compared to the corresponding months in 2013, with the exception of the month of June.
Theoretically, stocks are valued at the present value of their expected earnings and if the discount rate used in the present value calculation goes up, then by definition the present value of the stream of earnings goes down. As the discount rate by which all global assets are valued increases, does that imply by definition that the value of those assets is lowered? Unless the economy strengthens to the point that earnings are growing at a pace sufficient to overcome the higher discount rate, then valuations could indeed be vulnerable given widespread expectations for higher interest rates.
Yields are expected to progressively move higher especially after mid-2015 when the Fed begins to raise the fed funds rate. We anticipate the yield curve to exhibit what is termed a bear flattener whereby the entire yield curve rises, but short-to-intermediate-term rates rises faster than long-term rates. The short-to-intermediate sectors of the yield curve are largely controlled by the level of the fed funds rate while the long end of the curve is mostly impacted by the expected inflation rate. The short end remains vulnerable to a change in the fed funds rate as the Fed reacts to improved economic growth. However, persistently low inflation, at least for now, is expected to limit the rise in long-term rates.
The bond market has withstood the unwinding of quantitative easing fairly well. The reality of tapering has been much less painful than the fear of it due to relative valuation, the situation in Iraq, and the fact that the tapering process has been very well telegraphed and carefully handled by the Fed. Should this equanimity continue for the next six months, the transition to higher rates may be less abrupt than it might be otherwise.
While the Fed has done everything possible to prepare investors for the rate increase, there is a distinction between taking the foot off the gas (tapering) and hitting the brakes (rate hikes). Historically, an actual increase in the fed funds rate is painful for bond investors in the short run. While the economy has had ample time to deleverage, investors may still react negatively when rate hikes actually happen, even when they know the hikes are coming.
Should we see a consistently rising rate environment as expected, credit spreads will widen although we do not anticipate they will widen much, or widen fast. Spread widening to some degree moves in an orderly fashion down the credit curve – junk bond spreads widen more and faster, but the process slows as you move higher in quality. As rates go higher, risk-free assets become more attractive on a relative basis at the expense of bonds with credit risk. Investors must go up in quality to get improved relative total return unless credit spread widening is so miniscule that higher coupon interest payments compensate for principal depreciation. Investors who two months ago had to buy a 10-year corporate bond to get a 3.0% yield may be able to buy a 10-year U.S. Treasury for the same yield. Or, rather than buy a high-yield bond, they may be able to get the same yield in a bond with higher credit quality.
The monetary system is awash in liquidity and the faster and the more orderly the Fed can drain it, the less it will impact inflation. Wage inflation leading to overall inflation is the bane of the bond market. Rates rising in response to an inflation scare can be more abrupt and have greater amplitude. On the other hand, if rates rise in response to the improving economy, the transition can be rather contained and orderly. If we see healthy GDP growth of 3.5% and housing is improving without wage push inflation, the bond market can handle that reasonably well; rates will go up but not to the degree they would if we were to see a whiff of wage inflation compel the Fed to raise rates even faster.
In the near term, technical factors are likely to continue to support municipal bond prices. If Treasuries sell off, then the municipal market should do relatively well because of supply/demand dynamics favoring municipals. On the corporate side, unless we have sector rotation out of corporates into another asset class like equities, or a credit event that widens spreads in general, spreads will likely remain compressed. Supply increased in the second quarter and spreads still tightened, so changes of that nature are unlikely to move the market significantly.
Geopolitical risks always exist although strengthening U.S. oil production could moderate the future impact of turmoil in the Middle East. The U.S. recently surpassed Saudi Arabia as the largest oil producer in the world, and Saudi Arabia asserts it can make up the difference should the supply of oil from Iraq diminish on the heels of the current security crisis in Iraq.
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This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).