Quarterly Market Update
Fixed Income Outlook
The announcement of a policy tweak in anticipation of improved economic data rocked financial markets worldwide and led to a challenging two weeks for bond and equity markets. Chairman Bernanke of the Federal Reserve (the Fed) announced during a June 19th press conference that as positive economic data continues to accumulate, the process of normalizing monetary policy following almost five years of quantitative easing could begin as early as September. The announcement rocked financial markets which have grown accustomed to the Fed’s easy money policy and sent investors rushing to sell bonds ahead of Fed action. The notion of reducing quantitative easing (QE) impaired not only the domestic bond markets but also shook overseas markets, particularly emerging market bonds. Global equity markets were also temporarily gashed.
Bond investor reaction to the announcement was more aggressive than one would normally expect. A snapshot taken at the end of the first quarter and again at the end of the second quarter would have almost entirely missed the chaos that occurred within the two-week window at quarter end. During that time selling became indiscriminant, spreads widened, the yield curve rose and liquidity dried up in both the taxable and tax-exempt markets. The Investment Company Institute reported $60.47 billion in bond mutual fund outflows during June, more than a third higher the $41 billion pulled in October 2008, previously the worst month for outflows. Prior to June, bond mutual fund inflows had been positive for 21 consecutive months1.
While the situation created some interesting buying opportunities, investors trying to sell bonds had no place to go. Buyers sat on their hands; no one wanted to buy longer maturity bonds until it was clear how far back the Treasury market was going to recede. Dealers were sitting on inventories that were not only becoming stale, but were gradually going further underwater as yields on the longer end of the curve moved higher. The situation snowballed and dealers ultimately took losses on their existing inventory just to get it off the books by quarter end. This exodus created incredible discounts on some bonds and a buying opportunity for those with cash.
Shortly after Chairman Bernanke spoke, a parade of Fed governors began back peddling, reassuring the markets that the Fed was in no hurry to begin tapering and that raising short-term interest rates was not on the near-term agenda. The Fed’s clarification calmed the bond market somewhat, although the primary impact was to simply tighten credit spreads.
Figure 1 – Yield on 10-Year Treasury jumps by over 40 basis points following Chairman Bernanke’s announcement that the Fed will begin to taper bond purchases.
Treasury Market – Yields Soar on Taper Fears
Half way into the second quarter, the yield on the bellwether 10-year Treasury was at 1.62%. In response to Chairman Bernanke’s comments, the yield jumped 100 basis points to a high of 2.62%. By quarter end the yield had settled at 2.49%. The increasing possibility that the Fed may begin to taper its bond buying program lifted the Treasury yield curve across all maturities. Intermediate and long-term Treasuries which are more price sensitive were hit the hardest.
For the quarter Treasuries were down 2.23%, and off 2.48% year-to-date.
Government Agency Spreads are Not Spared
Historically, yields on agency paper are closely correlated with Treasury yields, but during the last two weeks of June spreads on 10-year Agency Notes widened 30 basis points, much the same as was seen in financials. The day before Chairman Bernanke spoke, Congressional discussion intensified regarding a bipartisan bill that would replace Fannie Mae and Freddie Mac with a new “public guarantor” as part of a broader plan to downsize the government’s role in the $10 trillion mortgage market. Because it was unclear how the new agency would work, uncertainty hit agency credits, making spreads on debentures widen all the more.
Corporate Market – Atypical Jump in Corporate Credit Spreads and Treasury Yields Pressure Prices
Corporate spreads widened by 20 to 30 basis points, a huge move, within a couple of days. Spreads widened at nearly twice the rate at which they had tightened in the previous quarter. Financial credits widened the most but all credits, including Industrials which normally trade in a tighter band, were impacted on a similar basis.
In what was yet another anomaly in a series of anomalies, corporate spreads widened simultaneously with the large spike in Treasury yields. Typically, corporate bond spreads widen in a declining Treasury yield environment and contract in a rising one. Falling Treasury yields typically offset the downward pressure on corporate bond prices when spreads are widening, but during the last two weeks of June, a confluence of widening spreads and rising Treasury yields pushed most corporate bond prices down sharply.
Surprisingly, the lowest-rated credits within the investment grade category managed to underperform Treasuries. Under normal circumstance, if the economy is improving, credit quality should improve simultaneously, and if that is the case, then lower-rated credits should outperform higher-rated ones. However, during the last two weeks of June, investors could get the same yield on higher-rated credits as they had previously only been able to obtain on lower-rated credits. Investors began moving up in quality to maintain or improve their yields as Treasury rates backed up, negatively impacting lower-rated credits. The Bank of America Merrill Lynch 1-10 US Corporate A-AAA Index posted a negative return of 2.26% whereas the Bank of America Merrill Lynch 1-10 US Corporate Index which includes BBB credits lost 2.49% for the quarter.
Tax-Free Bond Market - Rising Yields and Outflows Trump Solid Fundamentals
The municipal market traded in step with the Treasury market until the last two weeks of the quarter when municipal yields decoupled as a result of reduced liquidity. Investors were selling tax-free bonds and bond funds, leaving little bid in the market. New issuance was tabled in many cases which helped reduce supply and stabilize prices to some extent.
Investors rushed to get out of municipal bonds at any price as the combination of fund outflows and rising Treasury yields pushed the asset class into the red. The Merrill Lynch U.S. Municipals Index 1-10 years A-AAA was down 1.61% for the quarter. The yield on generic 10-year AAA-rated municipals which ended the first quarter at 1.91% rose to 2.56% by June 30th.
Figure 2 – Total returns by fixed income asset classes – Treasuries, Agencies, Corporates and Municipals over the second quarter in comparison to year-to-date.
Fixed Income Outlook Highly Dependent on Jobs Market
For the past three years a seasonal bias has emerged in the labor data whereby the number of new jobs added on a monthly basis starts the year on a strong note, but begins to swoon in the second quarter. While we have avoided the onset of the seasonal bias thus far, it is quite possible that the swoon has only been delayed until July or August. However, because the unemployment rate heading into the summer months is lower than in previous years, it could be an indication that the economy will continue to expand.
The direction of the bond market is more economic-data dependent than usual. Chairman Bernanke said that the Fed is nowhere near considering a Federal Funds rate increase and that even tapering is a function of the data. Payroll numbers are the most important data because the Fed’s accommodative policy has been pegged to the unemployment rate and the inflation index. We expect to see an increasing amount of market volatility centered on the first Friday of each new month when employment numbers are released.
The Fed originally targeted an unemployment rate of 6.5%. The unemployment rate actually increased to 7.6% in June from the recent low of 7.5%. We do not expect the unemployment rate to decrease rapidly because of massive increases in the labor participation rate (i.e. more people actively seeking jobs). It will not be easy to wring out this last percentage point or so in the unemployment rate.
Should monthly payroll gains continue at 175,000 or higher, then the Fed will likely stay on course to begin tapering QE3 in September and stop QE altogether in 2014. But because we have recently seen increases in weekly unemployment claims, the July labor data could disappoint. Should payroll numbers weaken between now and the end of the year, then that is a whole new ballgame for the Fed.
Other key data that the Fed is tracking includes the ISM Manufacturing and Non-Manufacturing Indexes, both of which are currently floating around 50. (Above 50 implies an expanding economy and less than 50 implies a shrinking economy.) Based on just these indexes, the economy is on the border between barely growing and contracting. Housing and retail sales numbers are also important measures that the Fed will watch closely going forward.
Undoubtedly the Fed wants the normalization of interest rates to be more orderly than what was experienced at quarter end, particularly with respect to the mortgage market. Housing is one part of the economy that is finally working after years of being stymied. As the Fed begins to taper QE from the current $85 billion per month down to $60 to $65 billion, it will do so by continuing to buy mortgage-backed securities while reducing purchases of Treasury bonds. While that will help mortgage rates relative to those of Treasuries to a certain extent, a rising Treasury curve will also push mortgage rates up over time.
That said, we also anticipate that the absolute level of Treasury issuance will begin to abate as the $1.2 trillion federal deficit is projected to shrink to $650 billion. Deficit reduction lowers the need to issue Treasury debt and should modestly reduce pressure on yields.
Should the long anticipated mass exodus by investors out of bonds intensify, interest rates will of course rise across the board, with yields on high quality bonds perhaps rising faster initially as investors sell their most liquid bonds first.
The consensus is that the yield on the 10-year Treasury is headed for 3.0% and eventually 3.25% in 2014. For the balance of 2013, at least from a technical standpoint, we anticipate that the yield on the 10-year Treasury will fall within a trading range of 2.5% to 3.0%. We are maintaining a below benchmark duration while continuing to overweight credits versus Treasuries and Agencies. Credit spreads widened last quarter, creating an opportunity for additional tightening. Earlier in June, there was not much room for spreads to tighten but Chairman Bernanke’s comments hit the reset button and because credit spreads perhaps overreacted, there is an opportunity for credits to tighten again going forward.
There is a good chance that the municipal market may rally on a relative basis because it was dislocated worse than any fixedincome asset class despite improving fundamentals. Ten-year AAA-rated Municipal yields were at 110% of Treasury yields at one point during the second quarter!
Many investors may be upset by bond performance as reflected on their June statements, but their July statement may show considerable improvement. Much of the credit spread widening and yield curve rise are being retraced so far in July, although not in their entirety.
Pockets of opportunity still exist in the bond market. Chaos creates opportunities when cash is available for investment. However, when cash is needed and bonds must be dumped, investors suffer. Just as it was in 2008 when the financial crisis began, in today’s bond market liquidity remains a critical variable.
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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).