Tuesday, August 21st, 2012
by Peter Tchir, TF Market Advisors
Is it a New EU?
Of the major players coming into June 2011, almost none are left. Attrition and elections have taken care of most of the major players. In fact, you could make a case that Merkel is really the only major player still in the same position.
I think this is important particularly for the ECB. Draghi has now had time to establish himself in his role, and get comfortable with the people at the ECB, the various central banks, and the politicians. He entered the role with a bang – a rate cut, more symbolic than anything, at this first meeting and then began the LTRO’s.
Since then, his efforts to get Spanish and Italian bond yields down have been thwarted by the markets and a deteriorating economic situation. He wants yields low and looks like he is prepared to stretch his powers to fulfill the mandate of “transmission of economic policies”.
How far is he willing to stretch? How much can he do based on that “transmission” mandate? That is the question and we need to get answers, but more and more, it looks like he is prepared to be aggressive. It may not be a completely new EU, but it has changed a lot in a year, and the ECB does look to be a new ECB.
Nein to Nein!
Germany looks more and more isolated in their refusal to play nice and even there it is becoming clear that not everyone is against the idea of money printing and aggressive actions. On top of that, Germany is “only” 25% of the EU economy. It is the single largest economy, but France, Spain, and Italy combined are much larger. Germany plays an important role, but it cannot make decisions unilaterally. Germany could in theory walk away from the EU, but the German “elites” more than anyone seem committed to trying to hold the Eurozone together. They are stubborn and have a deep seated fear of somehow once again being the ones that cause Europe to splinter.
Their voice, while important, is diminishing, and for many of them, they are looking for ways to save face as they backtrack from 2 years of causing problems. Assuming Nein means Nein is likely to be wrong in this case.
The Immediate Problems that the ECB CAN Address
Currency exit and forced redenomination has to be taken off the front pages of the newspapers. I have not seen a single paper that walks through how redenomination would work in practice. There are 100′s that talk about an event, and then a future where the currency adjustment “restores equilibrium” or some such nonsense, but they gloss over how you get to that stage. The reality is that you don’t. Not easily and possibly never. The uncertainty created will cause business to die. To die quickly and violently as no one will want any part of cross border commerce while currencies and laws are in a state of flux. This isn’t just for the weak countries. Germany will see problems as well as they face political backlash from the rest of Europe and from a strong currency. A lack of energy resources makes this reversion to old currencies and devaluation even more problematic.
While currency redenomination risk remains on the front burner, business will be slow to engage in big new projects and the risk of bank runs remains high.
Any policy that provides funds direct from the ECB to weak countries, such as the plan floated this weekend, would immediately reduce the risk of redenomination. The ECB would become the center of a tangled web, so intricate and complete it would be hard to visualize how to untangle. So the ECB CAN take redenomination risk of the table.
Budget problems in Spain and Italy need to be fixed. The ECB cannot do much to fix the overall budgets of Spain and Italy, but it CAN help. Both countries have seen cost of new money increase dramatically and are paying rates far above the ECB’s target rate for banks. That adds to the annual budget deficit as that higher interest rate cost affects current year payments. It takes time for these higher rates to influence the overall cost, but we are well over a year into the crisis and if Spain and Italy had been able to refinance all that debt 2% cheaper, it would be having an impact. The circular nature of this is vicious as well. The more Spain and Italy have to pay to refinance debt, the bigger their current deficits, and the lower their credit quality, causing rates to go higher. This is the “transmission” element the ECB is focusing on. The ECB wants (in fact needs) Spain and Italy to have low rates, and needs to find a way to get them. It will reduce current deficits and future projected deficits.
An ECB plan to support countries would take away roll risk, so not only would the countries that need money the most, be able to get it at rates in line with overall policy, but they could spend less time on how to raise money in the bond market, and more time on how to fix their economies and budgets. So the ECB program can help the budgets, it will take time, but it is real, and will also allow countries to focus on things other than bond auctions.
Constraints in both Will and Way
Throughout the crisis there have been concerns about whether the EU had the will or the way to fix the problem. Much of the conversation revolves around the “way” they can fix it. Do they have the tools? Do the treaties allow them to do what is necessary? The reality is that the “way” argument was to hide the fact that Europe didn’t have the “will” to fix things.
Now it looks like Europe might have the “will” to fix things. That Europe is finally willing to engage in a wholesale effort to support the periphery. If Europe is willing to do that, they can find ways. EFSF, while lacking in many respects, isn’t insignificant. The ECB, while constrained by its mandate, seems to have some flexibility, especially if they decide they want to push the envelope. A lack of will has been a bigger impediment to success than a lack of way, so this psychological change is important.
It is also useful to point out that so far the term “bailout” has been applied very loosely. Germany, for example has delivered very little cash to any of the countries. It has guaranteed debt that was used for the countries or supported IMF and ECB efforts to funnel money to the countries, but very little German cash has found its way to the countries as part of “bailouts”. On top of that, all nations that have received “bailout” money have continued to pay that money back. There has not been a single default on any money lent as part of the “bailouts” so Germany is actually profiting from this so far (ignoring the cheap rates they are also benefitting from).
The image of German’s dumping money on these nations just isn’t correct. So far, Germany has acted more like Rumpelstiltskin and demanded a high price for their loan, rather than as some sort of charity act that the term “bailout” implies.
Even though I believe the will is now much stronger, and there is a way, they will be careful not to be “reckless” and will embark on programs that are easier to sell internally.
What Trades Should do Well?
I like Spanish and Italian bonds, but only with maturities of less than 5 years. I think that the ECB will focus on the primary market and the short end of the curve. I think they will make money available in the 2 year range. It is long enough to offer real support, but short enough that the political opposition will be lower. I don’t exactly agree with the theory that 2 year risk is so much less than 5 year or 10 year in the case of Spain or Italy, but politicians tend to. Politicians often have a simplistic view and will take comfort in that the next 2 years are “foreseeable” and 5 years and out isn’t. It’s not true, since they can’t seem to anticipate anything 3 months out, but that is what they believe. They can be convinced to lend short term rather than long term.
I would go out as much as 5 years because any such program will be in place for awhile so even if loans are only for 2 years, there will be a window during which they are available. That will support the 5 year point. The 5 year point is also aided by bad CDS shorts and is in the comfort zone of banks.
The threat of subordination will keep the curve extremely steep. Even if the program were to be “senior unsecured” and pari passu with other debt, there would be doubt in the minds of investors. There should be concern that if things don’t work out, that non public holders would once again (like Greece) bear the brunt of the initial restructuring. So the curve should be steep as it prices in risk that any program goes away AND that bonds not part of the program would be subordinated. The ECB needs to ensure that countries have access to cheap money, but they don’t need to support the secondary market, and they don’t need to lend to countries for long term (it would be good if they did, but it isn’t necessary for the ECB’s objectives to get accomplished).
Spanish and Italian stocks, Bank stocks, and bank CDS. The best analogy I can think of is that this is like an earthquake and the “damage” will be greatest around the epicenter. So if the ECB launches on a new program, the epicenter of the earthquakes will be in Italy and Spain. The closer to the center the more benefit. Italian and Spanish banks are sitting right on the fault line and will benefit the most from this action. Companies in these countries should also see a rebound. Banks outside these countries will benefit more than companies. In many ways, the rest of the world has decoupled from the problems (DAX is up 20% YTD), but banks have been held back more than other companies because of how interconnected the global banking system is. This would extend as far as U.S. banks.
Credit Default Swaps. I continue to believe that CDS can go tighter. It will be led by bank CDS, but will be helped along as shorts capitulate. CDS has become the last bastion of “cheap shorts”. Too many investors are short, some whose primary knowledge of CDS came from reading “The Big Short”. I continue to see a lack of interest in bank hedging, and if “real money” ever decides to stop chasing the same silly bonds to the same silly yields and sells CDS instead, the gap will be ferocious. CDS spreads aren’t at the tights of the year yet, and have been stubborn these past few days (tighter, but grudgingly so). High yield bond and leveraged loans should continue to do well, but at this stage, high quality, BB type paper should be traded with a rate hedge.
Short German, French, and EFSF bonds. As the realization that your bunds aren’t about to get converted into Deutschemarks any time soon hits, these will look expensive. As EFSF is called upon to use up its remaining capacity, the supply will add to pressure to this particular entity, above and beyond the pressure on German and French yields. While I would be uncomfortable owning 10 year bonds in Spain and Italy, getting short 10 year bonds in Germany, France, and EFSF seems fine. The subordination argument that makes 10 year scary on the one side doesn’t directly translate to making it appealing on the other.
US stocks are the “dirtiest shirt” and far from the epicenter. The US has largely decoupled. We are about to start facing our own problems, and the campaign format that we will face them in, is particularly troubling. We rally because everyone in China is going to buy a iPhone despite evidence that China is having much bigger trouble than access to iPhone. US stocks will go along with the global rally, but I expect them to lag.
China. Tempting, but I’m not comfortable yet. Japan, maybe? I am working on forming a better opinion here, but suspect they will outperform the U.S. market on European action, but still underperform Europe itself.
Short, nervous, and rebalancing.
I shifted from being long to finally having gotten short on Friday. I don’t like that position right now. I will be shifting back to a more positive position. I think I will be between small short and small long, with longs continuing to focus on Spain, Italy, banks, and the credit positions mentioned above. Shorts will become more common and will be focused on U.S. markets. It is hard to be long Spain here after a 20% run from the lows, but I find that I gag less when looking at that, than other options for being long.
On the option front, I have started buying S&P September puts. I will look at increasing that position once I’m out of more of my short, but will continue to be patient as I think we will see a move higher in index values and see a drop in the cost of vol.
I will definitely be taking this morning’s fade as a chance to take off shorts and get back to a long bias.
Tags: Aggressive Actions, Attrition, Bond Yields, Central Banks, Decisions, Draghi, ECB, Economic Policies, Economic Situation, Economy, Elections, Elites, Eurozone, Fear, First Meeting, Mandate, Merkel, Money Printing, Politicians, Tf
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Saturday, August 11th, 2012
The Economy and Bond Market Radar (August 13, 2012)
Treasury yields rose for the third week in a row. It is interesting that as we get closer to additional monetary easing in the U.S., Europe and China, the Treasury bond market has already anticipated that and is selling into the news. This would follow a similar pattern as the two quantitative easing programs in 2009 and 2010, as bond yields moved higher immediately after the announcements.
- Initial jobless claims fell to 361,000 this week, indicating a somewhat better job dynamic than a couple of months ago.
- The Labor Department reported that job openings in June were the highest since July 2008.
- The U.S. trade deficit narrowed to $42.9 billion in June, lower by more than $5 billion. Exports grew while imports contracted.
- New foreclosures rose 6 percent in July, the third monthly increase in a row.
- European economic data remains weak as Italian GDP has contracted for four quarters in a row.
- Economic news out of China was weaker than expected for July as exports grew a meager 1 percent and industrial production was weaker than expected.
- The ECB appears ready to implement some form of quantitative easing in the very near future.
- With weak economic data out of China this week, odds of additional easing measures continue to move higher.
- Interest rates are likely to remain very low for the foreseeable future.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
- China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.
Tags: Bond Yields, Decisive Action, ECB, Economic Data, Economic News, Foreclosures, GDP, Hurry, Initial Jobless Claims, Italian Gdp, Job Openings, Labor Department, Market Radar, Quantitative Easing, Quarters, Shifting Focus, Trade Deficit, Treasury Bond Market, Treasury Yields, Wildcard
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Thursday, July 26th, 2012
by Scott Ronalds, Steadyhand Investment Funds
We’ve been vocal about our aversion towards federal government bonds. We noted in our Q2 Report that the Government of Canada 10-year benchmark bond yield dropped below 1.6% in June, and 10-year U.S. Treasury yields sit below 1.5%. Both Canadian and U.S. government bond yields are at or near all-time lows. Further, the German government issued 2-year bonds at auction last week which produced a negative yield for the first time ever. In other words, investors are willing to pay the government to park their money for two years.
These record low yields are an indication that investors much prefer the safety of bonds over stocks. We feel this safety is misplaced. Government bond yields have little room to fall further, thereby limiting their capital appreciation potential (when yields fall, prices rise), and the interest they are paying is paltry. Further, a rise in interest rates would be detrimental to government bond prices. We feel there are better opportunities elsewhere, notably corporate bonds. And in particular, U.S. banks.
The manager of our Income Fund, Connor, Clark & Lunn, believes that select bonds issued by large U.S. financial institutions offer compelling value. This is a contrarian view as negative sentiment still overhangs the U.S. financial sector, but many banks are in much better financial shape than they were a few years ago. They have recapitalized their balance sheets and restructured their housing exposures. Further, CC&L has a more positive outlook for the U.S. housing market as there are increasing indications that the sector has bottomed. While the manager doesn’t expect a rapid recovery, they feel the downside is limited and certain companies are well positioned to benefit from stabilization in the housing market. More specifically, they have increased the portfolio’s holdings in bonds issued by Citigroup and Bank of America (all foreign currency exposure is hedged).
Higher interest payments and yields are one attractive aspect of these bonds – they offer yields that are currently 2½ – 3% higher than 10-year U.S. Treasuries. Another benefit is that the manager believes their prices will be correlated (positively) to interest rate movements, which will help protect the portfolio in a rising rate environment, yet still provide a higher income stream until such an occurrence materializes.
The high yield sector is another area where CC&L is seeing value. The manager is finding opportunities in bonds issued by financial and consumer-related businesses as well as real estate investment trusts (REITs). Their focus is on businesses that are in a sound financial position and are producing strong operating results and growing their earnings. Examples include Great West Life, Hertz and Norbord (a producer of engineered wood-based panels used in the construction industry).
We’ve been advising clients for a while to be light on bonds in relation to their strategic asset mix, as we feel stocks are more attractively valued. That said, we don’t dislike all bonds. Corporate and high yield securities are our friends. This is reflected in the positioning of our Income Fund.
Tags: Bank Of America, Bond Prices, Bond Yields, Canadian, Canadian Market, Capital Appreciation, Connor Clark, Contrarian View, Corporate Bonds, Currency Exposure, Financial Shape, Foreign Currency, Government Bond, Government Bonds, Government Of Canada, Negative Sentiment, Q2 Report, Rapid Recovery, Steadyhand, Time Lows, Treasury Yields, U S Treasury
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Saturday, July 21st, 2012
The Economy and Bond Market Radar (July 23, 2012)
Treasury yields headed modestly lower again this week. Retail sales were much weaker than expected. Inflation and manufacturing data were more or less in line with expectations, while housing data was mixed. By Friday, European financial concerns had resurfaced as Spanish 10-year bond yields spiked above 7 percent and hit new highs. Spain indicated its recession will likely continue into next year. U.S. treasuries remain a safe haven for global investors, pushing yields lower this week.
- Industrial production rose 0.4 percent, ahead of expectations and a bright spot in an otherwise lackluster week for economic data.
- Real estate lending in China jumped 20 percent year-over-year in the second quarter and already shows Chinese policy-makers are taking aggressive action to combat the ongoing global slowdown.
- Housing starts rose 6.9 percent in June and the National Association of Home Builders confidence index had its biggest increase since September 2002.
- Retail sales fell 0.5 percent and have now fallen for three months in a row, which bodes very poorly for second-quarter GDP growth.
- The Conference Board’s Leading Index fell 0.3 percent in June, also indicating lackluster growth.
- Auto sales in the European Union fell 2.8 percent in June for the ninth consecutive monthly drop.
- With growth tepid, the Federal Reserve will not only remain accommodative, it may increase accommodation in the next few months.
- Europe remains a wildcard with the markets shifting focus on a weekly basis.
Tags: Aggressive Action, Auto Sales, Bond Market, Bond Yields, Chinese Policy, Confidence Index, Economic Data, Financial Concerns, GDP Growth, Global Investors, Global Slowdown, Housing Starts, Market Radar, National Association Of Home Builders, New Highs, Quarter Gdp, Safe Haven, Shifting Focus, Treasuries, Treasury Yields
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Saturday, July 14th, 2012
The Federal Reserve and other central banks manipulate interest rates every day, James Grant of Grant’s Interest Rate Observer told CNBC’s “Closing Bell” on Thursday. “The Fed is in the business of trying to manipulate markets, the macro economy, interest rates, unemployment and inflation through various monetary means, including the twisting around of yield curves and interest rates,” Grant said. Grant added, “The Federal Reserve fixes rates on principle. They have ‘operation twist’ that manipulates the credit markets. They have quantitative easing that manipulates bond yields.”
Tags: Bond Yields, Central Banks, Closing Bell, Cnbc, Credit Markets, Federal Reserve, Grant Federal, inflation, Interest Rate Observer, Interest Rates Unemployment, James Grant, Macro Economy, Principle, Quantitative Easing, Yield Curves
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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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Monday, July 2nd, 2012
The Perils of Prophecy
by J. Bradford DeLong, via Project Syndicate
BERKELEY – We economists who are steeped in economic and financial history – and aware of the history of economic thought concerning financial crises and their effects – have reason to be proud of our analyses over the past five years. We understood where we were heading, because we knew where we had been.
In particular, we understood that the rapid run-up of house prices, coupled with the extension of leverage, posed macroeconomic dangers. We recognized that large bubble-driven losses in assets held by leveraged financial institutions would cause a panicked flight to safety, and that preventing a deep depression required active official intervention as a lender of last resort.
Indeed, we understood that monetarist cures were likely to prove insufficient; that sovereigns need to guarantee each others’ solvency; and that withdrawing support too soon implied enormous dangers. We knew that premature attempts to achieve long-term fiscal balance would worsen the short-term crisis – and thus be counterproductive in the long-run. And we understood that we faced the threat of a jobless recovery, owing to cyclical factors, rather than to structural changes.
On all of these issues, historically-minded economists were right. Those who said that there would be no downturn, or that recovery would be rapid, or that the economy’s real problems were structural, or that supporting the economy would produce inflation (or high short-term interest rates), or that immediate fiscal austerity would be expansionary were wrong. Not just a little wrong. Completely wrong.
Of course, we historically-minded economists are not surprised that they were wrong. We are, however, surprised at how few of them have marked their beliefs to market in any sense. On the contrary, many of them, their reputations under water, have doubled down on those beliefs, apparently in the hope that events will, for once, break their way, and that people might thus be induced to forget their abysmal forecasting track record.
So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.
But we – or at least I – have gotten significant components of the last four years wrong. Three things surprised me (and still do).
Continue Reading this article
J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau for Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates.
Tags: Bond Yields, Dean Rohrer, Financial Crises, Financial History, Financial Institutions, Fiscal Austerity, Fiscal Balance, History Of Economic Thought, House Prices, J Bradford Delong, Jobless Recovery, Lender Of Last Resort, Monetarist, Project Syndicate, Rapid Run, Reputations, Solvency, Sovereigns, Term Crisis, Term Interest
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Monday, July 2nd, 2012
The Economy and Bond Market Radar (July 2, 2012)
Treasury yields were little changed for the week but show a downward bias. The week was volatile as the market braced for two events, the Supreme Court ruling on healthcare legislation and the EU Summit. While the healthcare ruling will likely affect us more directly the bigger news of the week for the markets was the proposals put forward at the EU Summit. Southern European countries rallied the most on the positive news with Spanish bond yields hitting the lowest level in three weeks, while German yields moved higher on the news.
- Durable goods orders rose a better than expected 1.4 percent in May, breaking a string of declines.
- New home sales rose 7.6 percent in May, which is the largest increase since April 2010. The supply of new homes also fell to 4.7 months, which is the lowest level in nearly seven years.
- In another confirmation of strength in housing, the S&P/Case-Shiller 20-city home price index rose 1.3 percent in April.
- Consumer confidence fell short of expectations and has now declined for four months in a row.
- Weekly initial jobless claims remain stuck in neutral and are indicating softness for the economy and the employment picture.
- The Brazilian central bank lowered its growth forecast for 2012 to 2.5 percent from 3.5 percent.
- The Fed 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.
Tags: 7 Months, Bond Market, Bond Yields, Brazilian Central Bank, Consumer Confidence, Declines, Durable Goods Orders, Healthcare Legislation, Home Price Index, Initial Jobless Claims, Interest Rate Policy, Market Radar, News Of The Week, Positive News, Shifting Focus, Softness, Southern European Countries, Supreme Court Ruling, Treasury Yields, Wildcard
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