Sunday, August 19th, 2012
Emerging Markets Radar (August 20, 2012)
- Malaysia’s second quarter GDP accelerated to 5.4 percent year-over-year, higher than the consensus 4.6 percent. CPI for July fell to 1.4 percent from 1.6 percent in June, lower than the consensus 1.6 percent.
- Chinese premier Wen Jiabao said China has more room for stimulus policies since inflation has come down. He also told local business people and government officials in Zhejiang province that the economy is stabilizing.
- China railway investment for the next five months is expected to be about 50 percent higher than the amount invested in the same period last year.
- Indonesia’s current account deficit widened sharply to $6.9 billion or 3.1 percent of GDP in the second quarter. The Bank of Indonesia (BI), therefore, tightened monetary policy by raising the deposit facility rate by 25 basis points to 4 percent which will push up the interbank borrowing rate. BI also strengthened the loan-to-value ratio to 70 percent for housing and vehicle loans.
- China’s July power demand grew 4.5 percent, lower than the 5.4 percent total demand growth year-to-date. Industrial power demand continued slowing.
- Taiwan’s second quarter GDP contracted 18 basis points, more than the estimate of 16 basis points.
- According to research from ING, the dividend effect on stock outperformance is healthy in emerging Europe and is most prominent among Turkish stocks, some of which pay close to a 10-percent dividend.
- Prior to ex-date, the dividend effect is driven by interest from high-yield equity funds. Post the ex-date, the dividend effect exists due to: 1) cheapness on a P/E basis; and 2) a dividend reinvestment effect into the stock and sector.
- Recovery in Property Transaction Should Improve Cash Flow for Chinese Developers
The chart below shows July’s housing transactions have picked up on a yearly basis. This will help cash flow for developers, and also reduce inventories. The housing market needs further inventory reduction before new starts can go up.
- The much hoped for bank reserve ratio reduction by the People’s Bank of China has not arrived. Liquidity tightness in the banking system has affected new loan growth, which will slow the growth recovery of the economy.
- As European policy-makers return from their usual long holiday, the German constitutional court may rule against current transfers.
- Republican and Democratic conventions in the U.S. may reduce the opportunity for compromise on the fiscal cliff.
Tags: Bank Of Indonesia, Basis Points, China Railway, Chinese Premier Wen Jiabao, Current Account Deficit, Dividend Reinvestment, Emerging Europe, Emerging Markets, Equity Funds, Five Months, Housing Market, Interbank, Outperformance, Premier Wen Jiabao, Property Transaction, Quarter Gdp, Value Ratio, Vehicle Loans, Wen Jiabao, Zhejiang Province
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Sunday, August 5th, 2012
The Race for Resources
By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors
The world watched in awe as American swimmer Michael Phelps became the most decorated Olympian of all time. I’ve read he’s been training in the pool for an average of 6 hours a day, 6 days per week, which equates to about 30,000 hours since age 13 and about 10,000 calories burned during a training day. It’s inspiring to see the incredible results of his tremendous sacrifice and commitment.
Investing in global markets requires the same sort of stamina, especially at times like this week, when the month’s reading on the manufacturing industry was not encouraging. The J.P. Morgan Global Manufacturing PMI of 48.4 for July was the lowest since June 2009.
However, I believe there are encouraging pockets of strength to energize and inspire investors.
For example, we’re coming up on the anniversary of the first stimulus move that kicked off the global easing cycle. On August 31, 2011, Brazil unexpectedly cut rates by 50 basis points, and since then, ISI says 228 stimulative monetary and fiscal policy moves have been initiated across several countries, including the Philippines, China, France, and Colombia.
In June and July alone, there were nearly 70 moves—the most since the world began this massive easing.
Generally, by the time central banks make a fiscal or monetary easing move, economic deterioration has already occurred. Even with these moves, it still takes several months for the stimulative measures to take effect and work their way through.
But while the world wades in the shallow end of the pool waiting for the economy to warm up, Asia has taken a deep dive into the energy space as they’ve recently announced acquisitions of Canadian resources companies.
In my presentations, I’ve discussed how resources companies have significantly underperformed their underlying commodities. During 2009 and most of 2010, the performance between oil and the S&P 500 Oil & Gas Exploration and Production Index was closely correlated. By the middle of 2011, oil and oil stocks started to separate, with crude continuing to rise while stocks deteriorated. Even with the recent drop in oil prices, oil stocks have continued to lag.
I’ve also discussed the strikingly similar trend occurring between gold and gold stocks. There’s been a spectacular pop in gold stocks recently, but it hasn’t been enough to catch up to gold’s performance.
The disparities mean that the cheapest resources are not found in the ground—they’re listed, and it’s been confirmed by recent energy company acquisitions.
Chinese oil company CNOOC put in a bid of $15 billion to purchase Canada’s Nexen. This was at a 61 percent premium to Nexen’s share price on July 20, according to Bloomberg. As you can see below, not only did the takeout announcement close the gap, now the company is outperforming the price of oil.
If CNOOC’s deal is approved, the state-run oil giant gets even bigger, gaining access to significant energy stores in several areas of the world, including Canada, the Gulf of Mexico, Colombia and West Africa, as shown below.
With a rapidly growing middle class and rising urbanization, Chinese leaders know they need to fill their country’s tremendous energy demands and are continually finding innovative ways to keep their country powered. CNOOC’s acquisition is one way China continues to acquire not only the resources needed to power the country, but also the technological innovations that come from countries with free markets and lower barriers to entry. According to The New York Times, China “has been garnering advanced production technologies to better draw oil and gas from nontraditional areas like deepwater fields and hardened rock formations.”
The other announcement came from Malaysia’s state-owned and natural-gas giant Petronas, which will purchase Canada’s Progress Energy Resources Corp. Petronas is one of the largest producers and shippers of supercooled LNG fuel in the world. According to the Vancouver Sun, the company is “anxious to increase its market share in Asia, where analysts expect demand to surge 75 percent by the end of the decade.”
After Petronas’ original bid was announced, Progress increased 74 percent—a record gain for the company, says Bloomberg. As shown below, Progress now dramatically outperforms the underlying commodity.
Ready to be a Buyer like Asia?
If you’re contrarian investor, there may be an additional reason to jump into the market today. According to research from J.P. Morgan, institutional investors have become extremely negative, as hedge funds “essentially short the market,” meaning that their expectation is that stocks will fall.
J.P. Morgan looked at the rolling 21-day beta of macro fund returns compared to the S&P 500 Index returns and found that the ratio is at an extreme level of -0.26. Research shows that the last two times the ratio fell this low—in September 2010 and February 2012—stocks rallied. In 2010, the S&P 500 climbed 26 percent in five months; in 2012, stocks rose 8 percent in two months.
These signs the market is sending out make it an especially attractive time to “mine” for investment opportunity. In July, we began to see energy stocks and oil get recharged, as the energy sector in the S&P 500 was the second best performer, increasing 4.17 percent and crude oil rose 3.68 percent. Unlike the start of an Olympic race, in investing, there isn’t a signal sounded to let you know when to dive off the starting block into the markets. Just make sure your portfolio is poised to participate in the race for resources.
Tags: American Swimmer, Basis Points, Canadian, Canadian Market, Canadian Resources, Central Banks, Chief Investment Officer, Deep Dive, Economic Deterioration, Frank Holmes, Global Markets, J P Morgan, Manufacturing Industry, Michael Phelps, Monetary And Fiscal Policy, Pmi, Policy Moves, Stamina, Stimulus, Training Day, U S Global Investors, Wades
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Sunday, August 5th, 2012
Emerging Markets Radar (August 6, 2012)
- Chinese President Hu Jintao presided over a Central Politburo meeting on July 26. He reaffirmed maintaining stable growth as the top priority and pledged to increase the policy support for the real economy. The frequent economic meetings hosted by the president and premier in late July suggest a higher probability for more follow-up measures soon to stabilize growth.
- China’s new bank lending may be about Rmb 700 billion in July, Economic Information Daily reports, showing the gradual rising of money supply.
- The Ministry of Railway announced that it plans to spend RMB470 billion on railroads and bridges this year.
- Money supply in the Association of Southeast Asian Nations (ASEAN) countries is robust, driven by infrastructure and property, and consumer spending. Singapore total domestic banking loans shows 20.9 percent growth year-to date by the end of June, while it is 12.6 percent for Malaysia, 26.2 percent in Indonesia, 14.6 percent in Thailand, and 14.7 percent for Philippines.
- Singapore’s unemployment rate fell in the second quarter to 2 percent from 2.1 percent the previous three months.
- China’s PMI, China’s official gauge of manufacturing activities, declined by 10 basis points from 50.2 in June to 50.1 in July. It is lower than market consensus of 50.5.
- Taiwan’s second quarter GDP was down 0.16 percent, versus the estimate 0.5 percent.
- Korea’s industrial production rose 1.6 percent in June, missing expectations for a 1.8 percent increase and down from May’s 2.6 percent.
- Thailand’s exports fell 4.3 percent in June while imports rose 5 percent, further demonstrating robust domestic demand in the country. Companies that are selling to the world market are, in general, seeing sales earning growth slow down, while those that sell to domestic demand, such as telecom, utilities and property companies, are still seeing robust growth. The same happens to China and other ASEAN countries.
- Hong Kong June trade growth missed expectations. Exports were down 4 percent year-over-year and imports down 2.9 percent.
- Korea’s second quarter GDP expanded 2.4 percent, growing at the slowest pace in almost three years, below the median estimate for a 2.5 percent gain.
- China’s Xi’an city said it would limit vehicle ownership to control traffic congestion.
- The recent strong support for the European project voiced by both the ECB and the German political establishment provides significant tail risk of increased forms of monetary policy support in the coming weeks.
- After the surprise July rate cut in South Africa, the market is pricing in a 25 percent chance that the Monetary Policy Committee will follow up with a further 50 basis point cut by year end. Monetary policy is already very accommodative and the policy rate is at multi-decade lows.
- Already representing 17.5 percent of the world’s population, India is projected to surpass China to be the most populous country in the world by the year 2025. With more than 65 percent of its population below the age of 35, it is expected that in the year 2020, the average age of an Indian will be 29 years compared to 37 for China.
- The dividend yield of telecom companies in Asia, excluding Japan, is close to 5 percent on average. The dividends are sustainable due to high free cash flow yield. This compares favorably with 10-year U.S. Treasury which yields less than 2 percent.
- Investors have heard many times from the Chinese government that it is committed to secure economic growth, but the government’s actions are still behind the curve. Particularly, its inability to find a balanced property policy will affect the growth of the economy.
- High household debt burden, reduced consumer purchasing power, and a relatively weak domestic growth outlook bode ill for banking sector growth in Brazil. Existing banking sector stress is likely to grow over the coming quarters on the back of declining interest rates and deteriorating asset quality.
- The Czech central bank forecasts gross domestic product to contract 0.9 percent in 2012, as measures to curb the budget deficit damp domestic demand. The economy relies on demand for cars, auto parts and electronics from the European Union, which buys about 80 percent of Czech exports.
Tags: Asean Countries, Association Of Southeast Asian Nations, Banking Loans, Basis Points, Chinese President Hu, Chinese President Hu Jintao, Economic Information, Hu Jintao, Market Consensus, Money Supply, Politburo, President Hu Jintao, Quarter Gdp, Robust Growth, S Industrial, Southeast Asian Nations, Stable Growth, Telecom Utilities, Top Priority, Unemployment Rate
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Sunday, July 29th, 2012
Emerging Markets Radar (July 30, 2012)
- The HSBC China July Flash PMI improved to 49.5 versus 48.2 in June, though it is still below 50. The manufacturing sub-index moved above 50, suggesting de-stocking pressure is lessened.
- The Nanjing local government announced supportive measures to provide an easy mortgage facility for first-time home buyers who participate in the city’s Provident Housing Fund. Although the central government has been making stern talks to continue to curb the housing market, its differentiated housing policy will stay and first-time home buyers will be supported by better mortgage rates.
- The Shangsha local government initiated Rmb 829 billion investments in 195 projects. This may show the ability of China to support economic growth. These projects are positive to commodity and machinery producers.
- Singapore industrial production jumped 7.6 percent in June, rising far more than the estimate of 2.8 percent growth. Increased pharmaceutical output countered a decline in electronic shipments.
- The Philippine central bank surprised the market by cutting its interest rate by 25 basis points to a record low 3.75 percent. The Philippines also reported a budget deficit of $278 million in June, mainly to improve the country’s infrastructure.
- The Bank of Thailand, the central bank, kept its benchmark rate unchanged at 3 percent, but revised GDP growth down from 6 percent to 5.7 percent for 2012 due to collateral impact from external factors. Thailand’s industrial production dropped 9.6 percent, and exports fell 2.5 percent in June.
- Hong Kong June trade growth missed expectations. Exports were down 4 percent year-over-year and imports were down 2.9 percent.
- Korea’s second quarter GDP expanded 2.4 percent, growing at the slowest pace in almost three years, below the median estimate for a 2.5 percent gain.
- Turkey and some other high-yielding emerging market countries (such as Russia) may find themselves the beneficiaries of Japanese investor interest previously directed at Brazil. Barclays estimates that potential portfolio flows to Turkey from Japan could reach $5 to 6 billion per year, or the equivalent of 0.8 percent of GDP.
- Philippine infrastructure investment has become a policy priority. In his “State of the Nation Address,” Philippine President Aquino stated “a large portion of our job generation strategy is building sufficient infrastructures,” focusing on airport, rail, and toll roads that would be built, upgraded and/or privatized. The market expects the policy to benefit companies specializing in construction materials and engineering, public utility, and property developers.
- China was exporting steel at the highest levels in two years last month. Its shipments abroad rose to 8.7 percent of domestic output, the highest proportion since July 2010, indicating soft domestic demand.
- The “whatever it takes” pledge from ECB president Mario Draghi in reference to saving the euro could come with conditions attached. RGE expects the ECB to restrict any assistance to Spain alone, given that Spain signed a memorandum of understanding.
Tags: Bank Of Thailand, Basis Points, Benchmark Rate, Budget Deficit, Easy Mortgage, Emerging Market Countries, External Factors, First Time Home, First Time Home Buyers, Gain Opportunities, GDP Growth, Housing Fund, Machinery Producers, Median Estimate, Mortgage Rates, Provident, Quarter Gdp, S Industrial, Supportive Measures, Time Home Buyers
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Saturday, July 14th, 2012
Emerging Markets Radar (July 16, 2012)
- China’s second quarter GDP was up 7.6 percent, in line with the market expectation of 7.7 percent. Asia markets were up after the data release. Fixed asset investment growth accelerated on stronger infrastructure, increasing 20.4 percent year-over-year for the first half of the year versus the forecast of 20 percent. Consumption was stable, rising 13.7 percent in June, slightly down from 13.8 percent in May, but better than the estimated 13.4 percent. Clearly, China is growing at a slower speed, which makes it possible for the government to stimulate with easing monetary and fiscal policies.
- China’s June new loans were RMB 919.8 billion versus the estimate of 880 billion, but short-term lending is still high at about 50 percent. Household lending was 30 percent, which explains why housing sales went up 41 percent in June.
- Korea unexpectedly cut its benchmark interest rate by 25 basis points to 3 percent.
- For the China Region Fund we find that the current market is offering plenty of investment opportunities of growth at a reasonable price (GARP) in the China region. The Fund’s portfolio currently has an average dividend yield of 3.4 percent with average revenue growth at 25 percent.
- China’s June industrial production was up 9.5 percent, lower than the estimate of 9.8 percent, but just slightly down from 9.6 percent in May. The growth of industrial production was still restrained by enterprises’ destocking and deleveraging, which has negative implication for the economic growth. As a leading indicator to China’s GDP growth, power output is in decline, flat in June, compared to 2.7 percent year-over-year growth in May.
Acceleration in Chinese Bank Lending Should Help Sustain Property Transaction Recovery
- After two interest rate cuts, China housing transactions have increased as home buyers can borrow at lower rate. In the meantime, the People’s Bank of China, the central bank, has encouraged banks to lend to first-time home buyers. The increased new loans in June are a positive sign that new loans are back on an upside trend.
- Although China’s June economic numbers are showing a steady economic growth, the trend can be on the downside, which makes the market believe the Chinese government will continue to spend to backstop growth weakness.
Tags: Asia Markets, Asset Investment, Bank Of China, Basis Points, Benchmark Interest Rate, China Region, Chinese Bank, Current Market, Dividend Yield, Emerging Markets, Fiscal Policies, Garp, GDP Growth, Housing Sales, Implication, Investment Growth, Investment Opportunities, Leading Indicator, Property Transaction, Quarter Gdp
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Wednesday, July 11th, 2012
by Scott Colyer, Advisors Asset Management
In the third quarter of 2011 the Economic Cycle Research Institute (ECRI) called for a 100% chance of a U.S. recession. They have a stellar track record of calling U.S. economic cycles. We noted this in our communication to clients at the end of 2011 and again in the first quarter of 2012. We gave the call credence because of who was making the call. What we also noted is that the ECRI estimated the severity of any slowdown to be shallow and fairly short-lived. Most recessions in the U.S. are over even before they are positively identified. Other very reliable indicators did not flash a U.S. recession and did not support the ECRI assertion which included a very positively sloped U.S. yield curve (still 100-110 basis points between the 30’s and 10’s).
The ECRI is very well thought of as Morgan Stanley reversed their bullish call on the U.S. equity markets back in August of 2011 based on the same data. Months and months have gone by since these calls were made. It now appears that we have a slowing economy based on the trajectory change in job creation and other monitors. Europe woes are the blame of the day. Is this the 2011 recession coming in 2012? I am not sure but I doubt it makes much difference to us.
Normally, a slowing U.S. economy would prompt Central Banks to ease monetary policy. However, right now, not only the U.S. Federal Reserve (Fed) has the monetary policy pedal already to the metal. Likewise, the global economies are easing at record pace. The point here is the Fed, if faced with a recession, will certainly move to implement QE3. We believe this would be supportive of higher U.S. equity prices and lower bond yields. The bottom-line here is that whether we are seeing a recession or just a soft patch in the economy, our investment thesis remains the same. With monetary policy GLOBALLY being the easiest in history, we would expect future returns in the equity markets to be greater than high grade debt. Additional QE measures should goose hard asset prices and tend to weaken the dollar. Income assets will be what investors will seek as traditional assets have little yield. This situation will be supportive of the prices of income producing assets.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.
Copyright © Advisors Asset Management
Tags: Basis Points, Bond Yields, Central Banks, Colyer, Credence, Economic Cycle Research Institute, Economic Cycles, Ecri, Future Returns, Global Economies, Investment Thesis, Job Creation, Monetary Policy, Morgan Stanley, Recession, Recessions, Record Pace, Slowdown, Trajectory Change, Yield Curve
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Monday, July 9th, 2012
July 6, 2012
by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
and Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today’s bond markets. In this issue we highlight the bond markets cautious response to the latest EU summit agreement; Q2 2012 performance between sectors of the global bond market; we address the Stockton, CA chapter 9 bankruptcy protection filing and take a closer look at Floating Rate Notes.
Bond Markets Rule?
European leaders surprised the markets with a more substantial agreement to stabilize bank and sovereign debt than expected. Risk markets rallied in response, but signals from the global bond markets were more cautious. On the day of the announcement, stock markets in Europe rallied as much as 6%, and economically sensitive commodities like crude oil rose by as much as 8%. However, the response in global bond markets appeared more cautious by comparison. Bond yields in Italy, Spain and Ireland declined by over 50 basis points the day the agreement was announced, but are still high relative to levels that prevailed at the beginning of the year and are still high enough to make reducing debt loads difficult. Moreover, German and US bond yields—considered safe haven markets—rose only modestly. Since many of the provisions included in the agreement were designed to appease bond holders, the divergence between the bond market reaction and the equity markets is notable. What is the divergence signaling?
- We believe it’s wise to heed the cautious response of the bond markets. Europe’s recent agreement reduces the risk of an imminent crisis in the banking sector and appears to be a step towards closer fiscal union. However, like everything in the markets, the devil is in the details. There is political risk because some of the terms of the agreement will need to be ratified by individual countries and then there is execution risk, since many of the plans have never been implemented before.
Ten Year Bond Yields
Source Bloomberg, as of June 13, 2012
- The key elements of the agreement… allow the European Stability Mechanism (ESM) to provide direct funding to Spanish banks rather than lending to the sovereign and it eases conditions for the bailout fund to buy government bonds. In addition, private bond holders will not be subordinated to ESM as was originally the case. These concessions to the bond markets should help ease the strains in the peripheral bond markets. Also, the European Central Bank (ECB) is to have supervisory responsibility for Europe’s banking sector, but the agreement did not specify a deposit insurance program.
- While the agreement helps ease immediate pressures, longer-term concerns linger. The ESM will most likely need more funding to have the fire power it needs to deal with Europe’s bad bank debt. Additionally, it isn’t clear how the ECB will become Europe’s banking supervisor since there is presently no structure in place for them to do so. Meanwhile, much of Europe is in recession with the most indebted countries experiencing very high rates of unemployment and contracting growth, making debt reduction and implementation of structural reforms even harder.
- Bottom line: We tend to favor the bond markets’ less enthusiastic assessment of the EU summit agreement over the other markets’ reactions. Europe’s latest agreement has eased the immediate crisis, but there is a long way to go towards stabilizing the economies and bond markets longer term. Given weakness in economic growth in the developed countries and ongoing risks in Europe, it’s reasonable that investors are likely to remain risk averse. For investors interested in international diversification, we continue to suggest minimizing exposure to European bond markets.
Q2 2012 Sector Performance
The theme of the second quarter can be described as “risk-off,” as weak economic data and the ongoing European debt crisis weighed on the markets. As a result, investors flocked to “safer” assets, driving the 10-year Treasury yield to an all-time low in early June. Although safety was a theme for the second quarter, most fixed income indices, including riskier benchmarks, generated positive returns as investors continued to search for yield. We believe that disappointing economic data and the Fed on hold until at least 2014 will keep Treasury yields low, and we continue to favor intermediate term investment grade bonds.
- Treasury rally drives returns for the Barclays US Aggregate Bond Index. High demand for Treasuries, as investors worldwide continued to seek safe-haven assets, helped drive strong returns for the US bond market. Declining interest rates instead of coupon income were the major source of return. The result was a yield to maturity of only 1.98% on the index, with an average duration (i.e. weighted average timing of interest and principal payments, and a measure of interest rate risk) of just over 5 years. Treasury rates remained near all-time lows, so there is not much room for interest rates to drop further. We believe that income will have to be the key driver for returns going forward. Our “lower for longer” mantra has not changed, and we expect interest rates to remain at low levels through year-end.
Q2 2012 Performance
Source Barclays, as of July 3, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.
- Investment grade corporate bonds generated positive returns across the board. High grade corporate bonds posted strong performance in the second quarter, as investors continued to search for yield in the current environment. The higher quality investment grade segments performed the best, with Aaa-rated bonds outperforming their lower-rated counterparts, and the utility sector, generally considered defensive, outperformed both financials and industrials. Corporate bond spreads, or the amount of yield over a comparable Treasury security, increased for the quarter. Such a trend is generally a sign of risk aversion. But it can also create opportunities in higher yielding bonds. Corporations have continued to reduce debt and boost their liquidity. We continue to favor investment grade corporate bonds with intermediate maturities in this environment, specifically the 5- to 7-year range.
- High yield returns show shift in sentiment to safer assets. Despite generating a positive return for the quarter, the high yield market underperformed both the higher quality investment grade index and the Treasury index. When investor risk aversion rises, high yield bonds tend to suffer as investors sell those securities and invest in higher quality or lower risk investments. For the quarter, the relative yield over Treasuries rose, negatively affecting the price of the Barclays US High Yield Index, which dropped by roughly 0.14%, while the income/coupon return was 1.97%, leading to a positive total return. This demonstrates the potential value of the high coupon, and showed how high yield can still generate a positive return in risk-off environments. For more aggressive investors, we do see relative value in the high yield market, as it offers a yield advantage of roughly 6.15% compared to Treasuries, but would exercise caution as multiple headwinds could push the risk premium even higher.
- Risk aversion negatively affecting the international markets. Euro zone troubles continue to dominate headlines and risk appetite. The so-called success of the Greek election was short-lived, as all eyes have turned to Spain, the most recent country asking for a bailout, and to a lesser degree, Italy. Foreign currency-denominated markets were negatively affected by the rise in the US dollar, leading to negative 0.4% return for the Barclays Aggregate ex-USD, an index comprised of government and investment grade bonds generally denominated in non-USD currencies. The Barclays Global Emerging Markets index was able to generate a positive return of 0.9%, although that index is denominated in the US dollar and the euro, not local currencies. Most emerging market currencies experienced declines for the quarter. In the current low rate environment, we think emerging markets may make sense for the aggressive portion of a portfolio, but a hedged approach may be best.
Stockton, CA and Muni Bankruptcy
Last week Stockton, California (pop. 292,000) became the largest U.S. city to file for chapter 9 bankruptcy protection. To most muni market watchers, the filing was no surprise. Markets have been tracking other issues, including limited new issue muni supply coupled with strong demand for tax-exempt yield more than headline risk related to individual credit stories. Stockton’s bankruptcy is another case in the growing, but still short, list of local governments in default or distress. While we expect that local governments will continue to face pressures, we believe that bankruptcy for municipal governments will remain rare.
- Stockton’s bankruptcy was widely telegraphed. Stockton’s decision to file follows a dramatic housing boom and bust in this primarily agricultural city in California’s Central Valley, followed by two years in a state of fiscal emergency, $90 million in cuts to balance the city’s budget (which is required by California state law), and 90 days of negotiation under a state law passed last year (Assembly Bill 506) which requires that cities negotiate with creditors before been eligible to seek bankruptcy protection, according to news reports and city press releases. A federal court must still accept the city’s petition.
- Municipal bankruptcies remain rare. Since 1937, when chapter 9 was added to federal bankruptcy code to allow for municipal bankruptcy, there have been just over 600 municipal bankruptcies, according to legal experts. Of that total, 43 have been from city and county issuers and, 33 of those cases were dismissed by a judge or did not reduce or discharge bonded debt, according to Bloomberg. Harrisburg, PA is one example. The court in Pennsylvania rejected the Harrisburg case after arguments that it violated state law. In 22 states, bankruptcy for local issuers is not permitted. And in 28 other states that do allow filing, there are varying requirements and limits to entering bankruptcy.
- Corporate bankruptcies are far more frequent, and different, than muni filings. Corporations can choose from two types of bankruptcy—chapter 7 and chapter 11. Chapter 7 involves liquidation. Chapter 11 is a form of rehabilitation, like hitting the “pause” button to negotiate and restructure. Chapter 9 bankruptcy is more like chapter 11 bankruptcy. Sizable municipalities are not generally able to simply fold up tent, liquidate, and disappear. There is also less precedent for how municipal bankruptcies operate, largely because they’re so uncommon. That is one of the key issues that many will be watching. How successful will the city be in reducing costs, and who will be most impacted in bankruptcy—retirees, bondholders, city employees or some combination?
- Bondholder protections depend on a bankruptcy court—and the class of bonds. In the case of Stockton, city financial statements show that the city’s debt includes lease revenue and pension obligation bonds that are secured and paid from general government revenues. These bonds do not have a dedicated tax source supporting them. Enterprise bonds, such as water and sewer bonds, are secured by net revenue pledges of the city’s water and sewer systems, which have not been the source of the city’s financial problems. “Since the pension and lease bonds are unsecured city obligations, they do not enjoy special protections in bankruptcy, subjecting them to possible debt service default and loss of principal,” argues Moody’s in a report downgrading Stockton bonds following the bankruptcy filing.
- Bankruptcy is not the same thing as default. Defaults can happen without bankruptcy, and vice versa. Bonds with dedicated revenues for projects not the primary cause of a municipalities’ distress have often been paid. Debt service on bonds that carry bond insurance will likely be paid by the bond insurer, with negotiations and losses covered by the insurer, not individual bondholders.
We suggest diversification, and a focus on tax-secured general obligation and/or essential service revenue bonds. While we don’t expect a significant increase in municipal bankruptcies, we do expect that many will continue to face strains from rising costs and the weak economic recovery. So we suggest diversification and a focus on high quality debt with the strongest possible protections. We still like general obligation bonds, with a dedicated pledge of property taxes—often called an unlimited ad valorem tax pledge in a prospectus—along with essential-service water and sewer revenues bonds from stronger, more stable systems as the core for most muni portfolios.
Are Floating Rate Notes the Cure in a Low-Rate Environment?
With the Federal Reserve holding short-term interest rates at zero and suppressing long-term rates through its bond buying programs, investors continue to search for investments with higher yields. Lately some investors have looked to floating rate notes, anticipating higher yield and less risk if rates rise. Not surprisingly, this relatively small corner of the fixed income market has become popular with retail investors for these reasons. In addition to mutual funds that offer access to floating rate notes (FRNs) there are also some new ETFs that have been launched in the past few years. An even newer development is that some major corporations are offering floating rate notes directly to small investors including employees of the corporation and positioning them as alternatives to money market funds.1
- At first glance…floating rate notes appear to offer an attractive alternative to fixed-rate bonds and notes. FRNs typically pay interest based on an index—such as the London Interbank Offer Rate (LIBOR). The notes usually have a “floor”—an initial rate for a specified period of time—often a few years—and then the rate adjusts or “floats” with the index. So if interest rates rise over time, the coupon payment will rise with the index. Sounds great, so what’s the catch?
- Credit risk—no cash substitute. Based on the Barclays FRN index, most floating rate notes are investment grade but not without credit risk. (We are not including leveraged loans in this discussion. Some mutual funds combine FRNs with bank loan, leveraged loans and convertible bonds.) About 65% of the issuers are financial companies and about 26% are issued by international firms. So, it is possible that a FRN fund or ETF would have exposure to international banks—a sector of the market that has seen many credit downgrades over the past two years.
For mutual fund or ETF investors, we suggest looking carefully at the holdings to make sure the credit quality is consistent with the investor’s risk tolerance. They should not be viewed as alternatives to cash investments or CDs. Deposit insurance doesn’t cover FRNs; they are subject to credit and interest rate risk, so they are not appropriate cash substitutes.
Breakdown of The Barclays U.S. Dollar Floating Rate Note (FRN) Index
Source Barclays, as of July 3, 2012
- Duration risk—may not be what you’re expecting. The duration for most FRNs is short, but some are issued with long maturities or are even issued as perpetual preferred securities. If long-term interest rates rise faster than short-term rates, then the value of the note could decline due to its long duration, even if the coupon rate moves up. Moreover, once the note’s floor expires, the coupon rate might actually fall if short-term rates don’t move up rapidly.For example, consider a perpetual preferred FRN issued in 2011, indexed to LIBOR with a three-year 4% floor that expires in 2014. At the beginning of 2015, the coupon will float at 25 basis points over LIBOR. If the Fed begins to raise rates in early 2015, the coupon payment might actually drop if the Fed’s rate hikes don’t reach the 4% floor rate. Meanwhile, if long-term rates rise in anticipation of a shift in Fed policy, which is usually the case, then the FRN would most likely trade lower due to its long duration. It could be the worst of both worlds. This may not be the case for most FRNs, but we advise being careful about the maturity of FRNs and as well as duration risk in floating rate note funds.
- Liquidity—can be thin. The market for floating rate notes is small relative to the size of the overall bond market and there may not be ample liquidity, particularly in times of financial stress. For investors who are investing in fixed income for safety and liquidity, this may not be an appropriate area for investment.
- Bottom line. FRNs can provide current income in excess of what’s available in cash investments without significant duration risk. However, FRNs and FRN funds and ETFs are not cash substitutes. Investors are exposed to credit, liquidity and interest rate risk. We suggest looking carefully at the investment vehicle that offers FRNs and limiting allocation to a small slice of the overall fixed income portfolio.
For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.International investments are subject to additional risks such as currency fluctuation, foreign taxes and regulations, differences in financial accounting standards, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.Income from tax-free bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.Past performance is no guarantee of future results.Diversification strategies do not assure a profit and do not protect against losses in declining markets.Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.The Barclays Global Aggregate Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component. Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody’s, S&P, and Fitch.Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.Barclays U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P, and Fitch.Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market.. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).Barclays U.S. Dollar Floating Rate Note (FRN) Index measures the performance of U.S. dollar-denominated, investment-grade floating-rate notes across corporate and government-related sectors. This index is not part of the US Aggregate Index, which is a fixed coupon index. Government-related sectors include sovereigns such as Mexico and Chile.London Interbank Offer Rate (LIBOR) is a widely used benchmark for short-term interest rates. It is an interest rate at which banks borrow funds from other banks in the London interbank market; the LIBOR is fixed on a daily basis by the British Bankers’ Association and derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and a full year.Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
Tags: agricultural, Banking Sector, Bankruptcy Protection, Basis Points, Bond Holders, Bond Market, Bond Yields, Chapter 9 Bankruptcy, Debt Loads, Devil Is In The Details, European Leaders, Global Bond Markets, Imminent Crisis, Political Risk, Reducing Debt, Risk Markets, Sensitive Commodities, Sovereign Debt, Stock Markets, Substantial Agreement, Summit Agreement
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Sunday, July 8th, 2012
The Economy and Bond Market Radar (July 9, 2012)
Treasury yields headed lower this week on disappointing economic reports and global central bank easing. Two key economic data points bookended the week, with a very weak reading from the ISM Manufacturing Index on Monday, followed by a subpar employment report on Friday. On Thursday we had what appeared to be coordinated global central bank policy easing with the ECB and the Bank of China cutting interest rates by 25 basis points, along with the Bank of England adding ?50 billion to their quantitative easing program. As can be seen in the chart below, the yield on the 10-year treasury fell to the lowest level in more than a month.
- Economic data is weak globally, forcing central banks to act which is sparking a bond rally and pushing down yields.
- Domestic auto sales remain a bright spot for the economy with GM, Ford and Chrysler all posting strong sales growth in June.
- Factory orders for May rose 0.7 percent, beating expectations.
- June nonfarm payrolls were weaker than expected, rising by a meager 80,000, little changed over the past few months.
- The ISM Manufacturing Index fell to the lowest level since July 2009 and indicated contracting manufacturing in June.
- European bond yields remain elevated even after central bank intervention and the EU summit the week before.
- The Federal Reserve reaffirmed its commitment to an ultra-low interest rate policy through 2014 and additional monetary easing is possible in the near future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China has obviously become more concerned about the economy and has eased twice in the past month.
Tags: 10 Year Treasury, Bank Of China, Bank Of England, Basis Points, Bond Market, Bond Yields, Central Bank Intervention, Central Banks, Domestic Auto, Economic Data, Economic Reports, Employment Report, Gm Ford, Interest Rate Policy, Ism Manufacturing Index, Market Radar, Nonfarm Payrolls, Shifting Focus, Strong Sales, Treasury Yields
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Sunday, July 8th, 2012
Emerging Markets Radar (July 9, 2012)
- China cut interest rates again this Thursday, effective Friday, July 6. The one-year benchmark lending rate was cut by 31 basis points to 6 percent, and the one-year benchmark deposit rate was cut by 25 basis points to 3 percent. In the meantime, the People’s Bank of China (PBOC) lowered the floor of lending rates to 70 percent of the benchmark rates from 80 percent, which was just lowered from 90 percent in the previous rate cut. It’s another asymmetric cut, but much less asymmetric than the previous cut.
- According to China International Capital Corporation, of the 16 cities it monitors, housing sales volume increased last week by 33 percent week-over-week, and 15 percent month-over-month. Year-to-date, average sales volume has risen 18 percent. Also in the housing market, Shanghai existing home sales surged 20 percent in June to a 17-month high of 19,300 units, Shanghai Daily reported, citing Century 21.
- Brazil’s inflation rate in June fell to the lowest level in nearly two years by rising 0.08 percent from a month earlier.
- Macau’s gambling revenue for June rose 12.2 percent to 23.3 billion patacas, versus market expectations of 15.3 percent.
- January to May profits at large and medium-sized Chinese iron and steel companies fell 94 percent year-over-year to Rmb 2.53 billion, the economic Information Daily reports.
- The Guangzhou government unveiled a purchase limit on some mid- and small-sized passenger vehicles license plates from July 1, with a yearly quota of 120,000 units or 10,000 units a month.
- Turkey, the fastest-growing economy after China and Argentina, saw its GDP shrink 0.4 percent (up 3.2 percent year-over-year) in the first quarter from the previous three months, promoting the market to believe an interest rate cut by its central bank.
- With further rate cuts, mortgage rates are lowered again. Particularly, PBOC has encouraged banks to lend to first-time home buyers. The best mortgage rate is a 30 percent discount to the benchmark rate. The chart below shows a downtrend in the ratio between monthly mortgage payments to income, showing improvement in housing affordability.
- Even with another rate cut within a month by China’s central bank, the market is still muted in Hong Kong and China. The best explanation might be the lack of liquidity in the banking system due to the lower Loan to Deposit (LTD) ratio, currently at 75 percent, and high bank requirement reserve ratio (RRR), currently at 20 percent. The market consensus is for China to cut RRR or reduce LTD soon. Also adverse to the economy is the weak loan demand this year, which might be improved by starting infrastructure projects and increasing consumption spending assisted by fiscal policy.
Tags: Bank Of China, Basis Points, Benchmark Rates, Century 21, China International, Economic Information, Emerging Markets, Existing Home Sales, First Time Home, Housing Market, Housing Sales, Inflation Rate, Iron And Steel, License Plates, Market Expectations, Mortgage Rates, Passenger Vehicles, Pboc, Sales Volume, Steel Companies
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Thursday, July 5th, 2012
by Russ Koesterich, Chief Investment Strategist, iShares
Here’s my take: I believe high yield bonds are close to fair value, I hold a neutral viewof the asset class and I advocate that investors generally maintain a benchmark weight.
That said, in the following three instances, I’d advocate investors consider being more aggressive buyers of high yield:
1.) If spreads widen. The spread between high yield bonds and the 10-year Treasury has generally fluctuated between 500 to 600 basis points this year, about where high yield should trade given the sluggish economic environment. However, assuming no further deceleration in the US economy, any further widening of high yield spreads back toward a premium of 650 to 700 basis points over the 10-year Treasury would represent a good buying opportunity, especially considering that many corporate balance sheets generally have been extremely strong and default rates have been low.
2.) If they have portfolios with high income needs. With a yield to maturity a little under 7% and volatility of less than 10%, a fund like the iShares iBoxx $ High Yield Corporate Bond Fund, (NYSEARCA: HYG) is an efficient way to add incremental yield to a portfolio. As such, investors may want to consider adding high yield bonds to their fixed income portfolios as their demand for income rises. For instance, while risk adverse investors may only want to hold around 10% of their fixed income portfolios in high yield, investors willing to take incremental risk to earn additional income may want to consider holding as much as 30% of their fixed income portfolio in high yield.
3.) If they are worried about rising rates. Investors who are worried about rising interest rates may also want to add high yield as a substitute for long-dated Treasuries. High yield bond funds currently have lower durations than Treasury funds, meaning that Treasuries are far more sensitive to interest rates. If interest rates rise even modestly, Treasury funds are likely to suffer larger losses than high yield bond funds.
Source: Bloomberg, iShares.com
The author is long HYG
The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling toll-free 1-800-iShares (1-800-474-2737) or by visiting www.iShares.com. For standardized performance for HYG, please click here.
Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.
Tags: 10 Year Treasury, Aggressive Buyers, asset class, Basis Points, Bond Fund, Chief Investment Strategist, Corporate Balance Sheets, Corporate Bond, Deceleration, Default Rates, Fixed Income Portfolio, High Yield Bond, High Yield Bond Funds, High Yield Bonds, Hyg, Neutral View, Rising Interest Rates, Treasuries, Treasury Funds, Yield To Maturity
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