Bill Gross: Investment Outlook (May 2013)

Wednesday, May 1st, 2013

“There Will Be Haircuts”

by William H. Gross

“Good as Money,” proclaimed the ad for Twenty Grand Cognac. Being a beer drinker, and never having cashed in a Budweiser to pay for a fill-up at the local gas station, I said to myself “Man, that must be really good stuff!” Even in a financial meltdown I thought, you could use it in place of cash, diamonds, gold or Bitcoins! And if the Mongol hordes descend upon us during a future revolution, who wouldn’t prefer a few belts of Twenty Grand on the way out, instead of some shiny rocks and a slingshot?

Well, not being inebriated at that moment I immediately shifted focus to a more serious topic. What IS money? A medium of exchange and a store of value is a rather succinct definition, but we generally think of it as cash or perhaps checks that reflect some balance of “ready” cash at a friendly bank. Yet as technology and financial innovation have progressed over the past few decades, and as central banks have tenuously validated the liquidity and price of various forms of credit, it seems that the definition of money has been extended; not perhaps to a bottle of Twenty Grand Cognac, but at least to some other rather liquid forms of near currency such as money market funds, institutional “repo” and short-term Treasuries “guaranteed” by the Fed to trade at par over the next few years.

All of the above are close to serving as a “medium of exchange” because they presumably can be converted overnight at the holder’s whim without loss and then transferred to a savings or checking account. It has been the objective of the Fed over the past few years to make even more innovative forms of money by supporting stock and bond prices at cost on an ever ascending scale, thereby assuring holders via a “Bernanke put” that they might just as well own stocks as the cash in their purses. Gosh, a decade or so ago a house almost became a money substitute. MEW – or mortgage equity withdrawal – could be liquefied instantaneously based on a “never go down” housing market. You could equitize your home and go sailing off into the sunset on a new 28-foot skiff on any day but Sunday.

So as long as liquid assets can hold par/cost with an option to increase in price, then these new forms of credit or equity might be considered “money” or something better! They might therefore represent a “store of value” in addition to serving as a convertible medium of exchange. But then, that phrase “Good as Money” on the cognac bottle kept coming back to haunt me. Is all this newfangled money actually “money good?” Technology and Fed liquidity may have allowed them to serve as modern “mediums of exchange,” but are they legitimate “stores of value?” Well, the past decade has proved that houses were merely homes and not ATM machines. They were not “good as money.” Likewise, the Fed’s modern day liquid wealth creations such as bonds and stocks may suffer a similar fate at a future bubbled price whether it be 1.50% for a 10-year Treasury or Dow 16,000.

But let’s not go there and speak of a bubble popping. Let’s perhaps more immediately speak about current and future haircuts when we question the “goodness of money.” Carmen Reinhart has said with historical observation that we are in an environment where politicians and central bankers are reluctant to allow write-offs: limited entitlement cuts fiscally, no asset price sink holes monetarily. Yet if there are no spending cuts or asset price write-offs, then it’s hard to see how deficits and outstanding debt as a percentage of GDP can ever be reduced. Granted, the ability of central banks to avoid a debt deflation in recent years has been critical to stabilizing global economies. And too, there have been write-offs, in home mortgages in the U.S., for example, and sovereign debt in Greece. But the cost of these strategies, which avoid what I simplistically call “haircuts,” has been high, and their ability to reduce overall debt/GDP ratios is questionable. Chairman Bernanke has admitted that the cost of zero-bound interest rates, for instance, extracts a toll on pension funds and individual savers. Some of his Fed colleagues have spoken out about the negative aspects of QE and future difficulties of exit strategies should they ever take place. (They won’t!) So current policies come with a cost even as they act to magically float asset prices higher, making many of them to appear “good as money” – shots of cognac notwithstanding.

But the point of this Outlook is that even IF… even IF QEs and near zero-bound yields are able to refloat global economies and generate a semblance of old normal real growth, they will do so utilizing historically tried and true “haircuts” that rather surreptitiously “trim” an asset holder’s money without them really knowing they had entered a barbershop. These haircuts are hidden forms of taxes that reduce an investor’s purchasing power as manipulated interest rates lag inflation. In the process, governments and their central banks theoretically reduce real debt levels as well as the excessive liabilities of levered corporations and households. But they represent a hidden wealth transfer that belies the vaunted phrase “good as money.”

Before drinking up, let’s examine these haircuts to see why they do not represent an authentic store of value even if their bubbly prices never pop. I will give each haircut a symbolic name – I welcome your suggestions as well via e-mail reply: outlook@pimco.com

(1) Negative Real Interest Rates – “Trimming the Bangs”

During and after World War II most countries with high debt overloads resorted to artificially capping interest rates below the rate of inflation. They forced savers to accept negative real interest rates which lowered the cost of government debt but prevented savers from keeping up with the cost of living. Long Treasuries, for instance, were capped at 2½% while inflation was soaring towards double-digits. The resulting negative real rates together with an accelerating economy allowed the U.S. economy to lower its Depression-era debt/GDP from 250% to a number almost half as much years later, but at a cost of capital market distortions.

Today, central banks are doing the same thing with near zero-bound yields and effective caps on higher rates via quantitative easing. The Treasury’s average cost of money is steadily grinding lower than 2%. If current policies continue to be enforced in future years it will eventually be less than 1% because of the inclusion of T-bill and short maturity financing. The government’s gain, however, is the saver’s loss. Investors are being haircutted by at least 200 basis points judged by historical standards, which in the past offered no QE and priced Fed Funds close to the level of inflation. Large holders of U.S. government bonds, including China and Japan, will be repaid, but in the interim they will be implicitly defaulted on or haircutted via negative real interest rates.

Are Treasuries money good? Yes. But are they good money? Most assuredly not, when current and future haircuts are considered. These rather innocuous seeming (-1%) and (-2%) real rate haircuts are not a bob or a mullet in hairstyle parlance. More like a “trimming of the bangs.” But at the cut’s conclusion, there’s a lot of hair left on the floor.

(2) Inflation / Currency Devaluation – “the “Don Draper”

Inflation’s sort of like your everyday “Mad Men – Don Draper” type of haircut. It’s been around for a long time and we don’t really give it a second thought except when it’s on top of a handsome head like Jon Hamm’s. 2% ± a year – some say more – but what the heck, inflation’s just like breathing air … you just gotta have it for a modern-day levered economy to survive. Sometimes, though, it gets out of control, and when it is unexpected, a decent size hit to your bond and stock portfolio is a possibility. If our TV idol Don Draper lives another decade or so on the airwaves, he’ll find out in the inflationary 70s. Such was the example as well in the Weimar Republic in the 1920s and in modern day Zimbabwe with its One Hundred Trillion Dollar bill shown below. As central banks surreptitiously inflate, they also devalue their currency and purchasing power relative to other “hard money” countries. Either way – historical bouts of inflation or currency devaluation suggest that your investment portfolio may not be “good as the money” you might be banking on.

(3) Capital Controls – the “Uncle Sam Cut”

Uncle Sam with his rather dapper white hair and trimmed beard serves as a good example for this type of haircut, if only to show that even the U.S. can latch on to your money or capital. Back in the 1930s, FDR instituted a rather blatant form of expropriation shown above. All private ownership of gold was forbidden (and subject to a $10,000 fine and 10 years in prison!) if it wasn’t turned into the government. Today we have less obvious but similar forms of capital controls – currency pegging (China and many others), taxes on incoming capital (Brazil) and outright taxation/embargos of bank deposits (Cyprus). Governments use these methods to keep money out or to keep money in, the net result of which is a haircut on your capital or your potential return on capital. Future haircuts might even include a wealth tax. Are gold and/or AA+ sovereign bonds good as money? Usually, but capital controls can clip you if you’re not careful.

(4) Outright Default – the “Dobbins”

Ah, here’s my favorite haircut, and I’ve named it the “Dobbins” in honor of this 5-year bond issued in the 1920s with a beautiful gold seal and payable, in dollars or machine guns! Bond holders got neither and so it represents the historical example of the ultimate haircut – the buzz, the shaved head, the “Dobbins.” As suggested earlier, the objective of central banks is to prevent your portfolio from resembling a “Dobbins.” I have tweeted in the past that the Fed is where all bad bonds go to die. That is half figurative and half literal, because central banks are typically limited from purchasing bonds payable in machine guns or subprime mortgages (there have been exceptions and Bloomberg reported that nearly 25% of global central banks are now buying stocks believe it or not)! But by purchasing Treasuries and Agency mortgages they have rather successfully incented the private sector to do their bidding. This behavior reflects the admission that modern-day developed economies are asset-priced supported. Unless prices can continuously be floated upward, defaults and debt deflation may emerge. Don’t buy a Dobbins bond or a Dobbins-like asset or a bond from a country whose central bank is buying stocks. They probably aren’t “good as money!”

Investment Strategy

So it seems as if the barber has you cornered, doesn’t it? Sort of like Sweeney Todd! Let’s acknowledge that possibility, along with the observation that all of these haircuts imply lower-than-average future returns for bonds, stocks, and other financial assets. If so, the rather mixed metaphor of “money’s goodness” and “avoiding haircuts” is still the question of our modern investment age. The easiest answer to the question of what to buy is to simply take your ball and go home. If the rules aren’t fair, don’t play. That endgame however, results in a Treasury bill rate of 10 basis points or a negative yield in Germany, France and Northern EU markets. So a bond and equity investor can choose to play with historically high risk to principal or quit the game and earn nothing. PIMCO’s advice is to continue to participate in an obviously central-bank-generated bubble but to gradually reduce risk positions in 2013 and perhaps beyond. While this Outlook has indeed claimed that Treasuries are money good but not “good money,” they are better than the alternative (cash) as long as central banks and dollar reserve countries (China, Japan) continue to participate.

The same conclusion applies to credit risk alternatives such as corporate bonds and stocks. Granted, this sounds a little like Chuck Prince and his dance floor metaphor does it not? His example proved that dancing, and full heads of hair are not forever. So give your own portfolio a trim as the year goes on. In doing so, you will give up some higher returns upfront in order to avoid the swift hand of Sweeney Todd. There will be haircuts. Make sure your head doesn’t go with it.

Quick Read

1) Central banks and policymakers are acting like barbers. They haircut your investments.

2) Negative real interest rates, inflation, currency devaluation, capital controls and outright default are the barber’s scissors.

3) Gradually reduce duration, risk positions and “carry” as the year proceeds.

William H. Gross
Managing Director

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investors should consult their financial advisor prior to making an investment decision.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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Tags: Bill Gross, Bonds, PIMCO
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Equities Rally But So Do Bonds – What Gives?

Tuesday, April 30th, 2013

by Mark Hanna, Market Montage

Chris Burba (@ChrisBurbaCMT on twitter) just posted this interesting chart showing a major divergence between how bonds and stocks are acting.  Normally bonds will sell off as equities rally as we go into ‘risk on’ mode.  However this week even as equities rallied, bonds held quite steady and on a day like today are acting very strong.  Yields continue to fall.  Even as equities “honeybadger” their way up.  So what gives?

Usually when there is a divergence between bonds and stocks people give the edge to bonds as the “smarter market”.  So it’s plausible this is some sort of headfake in the equity market and bonds are giving us a warning.  In any normal market that is the thesis I’d focus on as would the herd.  But we are in a QE market.  A global QE market.  We are seeing strange things like Spanish and Italian debt yields plummet of late.  Why?  One potential reason in my mind is the Japanese money now flooding the world.   That money is desperate for yield – so a 4% Italian bond looks juicy especially with the inherent backstop of the ECB.  Even a 1.6% U.S. yield looks tasty in a relative sense.

So as with almost everything nowadays we have to try to figure out if the normal market signals that worked for decades are useless now under a global QE regime.  There are only so many assets in the world to buy.  If too much money is chasing them they get overpriced.  That can work for stocks just as for bonds – which in the latter case would be showcased by a drop in yields.   I don’t know the answer and none of us do as we are living in a great experiment of monetary policy.

As an aside, another fellow on twitter mentioned this morning that this is the first time in 17 years the U.S. market has not had a 5%+ correction in the first 4 months of the year.   More strange and interesting things in our QE world.

*** One should note that since 2009 of course the bond market is not trading “freely” – so the price action of bonds since that time can always be called into question as their has been an almost persistent bidder in that market with the exclusion of the small breaks between QE1 and QE2 and QE2 and QEunlimited.

Copyright © Market Montage

Tags: Bonds, Equities
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Bonds 101: Yields, Prices, And Inflation

Friday, April 26th, 2013

We recently showed 220 years of US Treasury bond yield history but all too often, the average investor is unfortunately unaware of the relationship between bond yields (interesting on a relative-value perspective) and bond prices (the thing that matters for your portfolio’s returns). The two measures are inextricably linked obviously (a higher yield implies a lower price and vice versa) but the relationship is not a straight line – it has ‘convexity’. The following charts may help understand the upside-downside changes from ‘yield’ movements, what the Fed is doing to the relationship, and how inflation expectations impact these changes.

Via Goldman Sachs:

Bonds are loans that investors make to governments, municipalities or companies, which typically pay the investors a fixed rate of interest until the bonds mature and the loans are repaid.

The most well-known US government bond is the 10-year US Treasury bond, which matures ten years from the issue date. Right now, investors can purchase a bond for $100 with a yield of about 1.7%, or about $1.70 per year – almost nothing! But there is a bond market that moves daily, so the price of bonds will move depending on interest rates and the economy.

Although investors can simply hold the bond they purchased until maturity and be paid back what they spent in full (plus the interest they’ve received), they can also sell the bond before maturity. What they get back, however, will depend on interest rates at the time that they sell. If interest rates have risen, then it will be harder to sell their lower-yielding bond, and they will have to sell it for less than they paid for it. If interest rates have declined, then other investors will want to own the bond, and the seller can charge more than they paid for it. So bond holders don’t fare well when interest rates rise.

The other thing that bond holders fear is inflation (which typically motivates rate hikes); when consumer prices rise, the interest investors get from bonds is worth less and less in real purchasing power terms.

And the yield varies depending on the maturity or length of the investment. The Fed is having a significant impact at various parts of the ‘curve’.

Charts: Goldman Sachs

Tags: 400, Bonds, Goldman Sachs
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Fixed Income = Broken Sentiment? (Bradley)

Friday, April 26th, 2013

By Tom Bradley, Steadyhand Investment Funds

My last post on gold spoke to the impact of investor sentiment on security prices. In the case of the shiny metal, sentiment is everything. As for other securities, such as bonds and stocks, it’s a secondary factor – economic fundamentals (profits) and valuation drive the boat.

Having said that, I find the market sentiment in the fixed income markets to be remarkable. I say that because the consensus around interest rates has two elements to it. One speaks to valuation (rates are unsustainably low) and the other to timing (rates won’t rise for a few years to come). In other words, the market thinks bonds are expensive now, but because of macro-economic factors, they’re going to stay that way for a few more years.

I bring this topic up again (and again and again) because investors have to be careful when valuation and sentiment are at extremes. Betting with the consensus is a hard way to make money at the best of times, but when it lines up with valuations being out of line, it can set the stage for a wild ride … in the wrong direction.

Hopefully, gold has served as a wakeup call when it comes to investor sentiment and strong consensus. That is: it will change; we won’t see it coming; and we won’t know why until after the fact.

The catalyst for higher interest rates could be any number of things – higher inflation, a better economy, rising stock markets. When long-term Government of Canada bonds lose 15% of their value, we’ll be saying, “What were we thinking … bonds were ridiculously expensive and everyone loved them!”

So beware of complacency. We are in unprecedented times when it comes to government finances and monetary stimulation. Other than the Leafs making the playoffs, we shouldn’t be too confident about anything right now.

Note: In response to the interest rate complacency, and valuations for the bonds and stocks, we have positioned the Founders Fund (and advised clients in relation to their long-term asset mixes) to carry a minimum weighting in bonds and hold some cash and short-term investments instead (10-15%). As for the bonds we hold, our manager, Connor, Clark & Lunn, is heavily tilted towards corporates, with little or no exposure to Government of Canada bonds. We’re recommending a regular allocation to stocks, but with a tilt towards foreign stocks over domestic.

Copyright © Steadyhand Investment Funds

Tags: Bonds, Fixed Income, Tom Bradley
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The Economy and Bond Market Radar (April 15, 2013)

Sunday, April 14th, 2013

The Economy and Bond Market Radar (April 15, 2013)

Treasury yields were little changed this week as global economic data was mixed and stocks rallied. U.S. economic data was generally weaker than expected, while Chinese data was generally better than expected. The University of Michigan Consumer Confidence Index fell to the lowest level since July and is somewhat symptomatic of the economic data of late. As can be seen in the chart, the pattern has been very choppy and more or less moving sideways. So while financial market sentiment improves, we aren’t necessarily seeing that improvement in the data.

click to enlarge

Strengths

• Chinese imports in March rose 14.1 percent, doubling expectations and signaling an improving Chinese economy. Chinese inflation slowed in March to 2.1 percent, which reduces pressure on the central bank to tighten monetary policy.
• Minutes from the Fed’s March 19-20 meeting more or less reiterated its commitment to QE and focus on job growth.
• Inflation data remains benign with import prices and producer prices both falling in March.

Weaknesses

• Retail sales fell 0.4 percent in March which was well below estimates. Poor weather played a role as it was unseasonably cold in many parts of the country.
• In addition to the University of Michigan Confidence Index mentioned above, the National Federation of Independent Business’s Sentiment Index (small business) also fell in March and hiring plans hit the lowest level in a year.
• Chinese bank loans surged in March, raising inflation concerns and potentially spurring government action to slow growth.

Opportunity

• The Fed continues to remain committed to an extremely accommodative policy.
• Key global central bankers are still in easing mode such as the European Central Bank (ECB), Bank of England and the Bank of Japan. The Bank of Japan in particular is aggressively easing currently.

Threat

• Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.
• Trade and/or currency “wars” cannot be ruled out, which may cause unintended consequences and volatility in the financial markets.

Tags: Bond Market, Bonds, Economy
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The High Yield Bond Market is Running Out of a “Margin for Error”

Thursday, April 11th, 2013

The five years that came to a close at the end of March will go down in financial history — and it was an extraordinary period for the group of bonds variously known as high yield, low grade, or junk.

The colors in the chart are carried from panel to panel, representing the Merrill Lynch indexes for BB, B, and CCC bonds.  (Here’s a crowd-sourced summary of the most common ratings systems.  The three categories shown here extend from “speculative” to “highly speculative” to “extremely speculative.”)

The top panel shows the returns and is interesting in several respects.  First, notice how the market held together for many months up until the Lehman debacle.  Not much warning from the market pricing mechanism even as the environment was deteriorating rapidly.  Second, these bonds bottomed well in advance of stocks.  (For your scorecard, from that bottom to 3/31, the CCCs returned 247%.)  Finally, notice that the junkiest bonds produced the best return and the least junky the next best; those in the middle had the worst returns.  That’s unusual.

In the middle panel are the absolute yields.  They are, of course, the foundation of subsequent returns.  The smart money that stepped up when the CCCs were at 40% yields had an opportunity for out-sized profits (and had nerve, which is not easy to come by) that are definitely not available today.  The yields on BBs and Bs are now half what they were in March of 2008, making it virtually impossible to replicate the returns you see in the chart.  (Yields on CCCs have only come down from 15.3% to 9.3%.)

The bottom panel plots the spread versus Treasuries for each part of the market.  As the yields on junk bonds were skyrocketing, they were plummeting on Treasuries.  Spreads in the thousands of basis points are unusual even for these low quality bonds.

Today we have a situation where investors have flocked in, even as the valuation picture has worsened as the yield cushion against inevitable problems has been depleted.  Nothing will necessarily happen tomorrow or the next day, but there’s no margin for error if something untoward does occur.  (Chart:  Bloomberg terminal.)

Tags: Bonds, brakke, high yield, Hyg, research puzzle
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Robert Shiller Calls Bond Market “Dangerous”

Tuesday, April 9th, 2013

Robert Shiller, who predicted the bursting of the tech and housing bubbles, now calling the bond market “dangerous”? He shares his views and advice on the stock, bond and housing markets. WealthTrack #940 Originally Broadcast 29 March 2013.

Tags: Bonds, Outlook, Real Estate, Shiller, Stocks
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The Economy and Bond Market Radar (April 1, 2013)

Saturday, March 30th, 2013

The Economy and Bond Market Radar (April 1, 2013)

Treasury yields fell for the third week in a row following continued uncertainty in Europe, even though a revised plan for Cyprus was put in place and banks reopened on Thursday to relative calm. Economic data was generally weaker than expected, which also likely played a role in sending yields lower. A good example is consumer confidence which came in well below estimates and somewhat surprisingly has just bounced around in a range for more than a year. Beginning-of-the-year tax increases and the sequestration continue to weigh on consumer confidence.

click to enlarge

Strengths

• Europe avoided a larger crisis by coming to a resolution on the Cyprus banking system, but the process does not instill a lot of confidence.
• The Case-Shiller 20-city price index rose 8.1 percent versus a year ago in January. Signs that the housing market continues to recover are very supportive of continued economic expansion.
• Durable goods orders rose 5.7 percent in February on a spike in aircraft orders.

Weaknesses

• Consumer confidence fell sharply in March as the economy lacks alacrity.
• Eurozone economic sentiment also fell in March after seeing steady improvement in recent months.
• Initial jobless claims rose to 357,000 this week, reversing a recent trend of better numbers.

Opportunity

• The Fed continues to remain committed to an extremely accommodative policy.
• Key global central bankers are still in easing mode such as the European Central Bank (ECB), Bank of England and the Bank of Japan. The Bank of Japan in particular appears willing to implement additional monetary policy easing in the near future.

Threat

• The economy appears to be gaining momentum. The risk for bondholders is that this trend continues and bonds sell off.
• Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.

Tags: Bonds, Economy
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Bond Outlook: Lower for Longer, But Not Forever (Kathy Jones, et al)

Monday, March 11th, 2013

March 8, 2013

by Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research
and Rob Williams, Director of Income Planning, Schwab Center for Financial Research
and Collin Martin, Senior Research Analyst, Fixed Income and Income Planning, Schwab Center for Financial Research

Lower for Longer, But Not Forever

We’ve been in the “lower for longer” camp for quite a while, based on our view that sluggish economic growth, tightening fiscal policy, and the Fed’s easy monetary policies would keep interest rates low for an extended period of time. However, we’ve become more cautious about holding long-term bonds over the past year, due to our concern that the risk of being caught in an unexpected sharp rise in interest rates was worse than giving up some of the potential capital gains to be had as bond yields fell to new lows. We are not market timers and we still believe that laddered portfolios with average durations1 in the intermediate term range make sense for many bond investors. But we are often asked: what will change our view on interest rates? The following is a short description of what we’re watching.

• Follow the money, jobs and the Fed. We look for bond yields to move up when the economy is strong enough to generate more jobs and income growth. We think it’s surprising how many forecasters have been looking for interest rates to “normalize” before those things happened. We don’t believe that there is a set of “normal” interest rates. There are long-term averages and historical relationships between interest rates and economic fundamental factors. These are useful, but we also have to factor in all of the “abnormal” factors—such as the Fed’s zero interest rate policy and quantitative easing program, the unfinished de-leveraging cycle in the developed world and demographic trends. We think the three key factors to watch are the growth rate in money and lending, employment and Fed policy.
• Money and Lending. Since the onset of the financial crisis, the Fed has created an unprecedented level of reserves in the banking system. However, the demand for money was relatively soft until last year. Stronger demand for money tends to lead to higher interest rates and stronger spending may lead to inflation. The pace of lending has picked up and as a result, nominal GDP growth, which tends to track credit growth, has picked up as well. But both lending and nominal GDP are still growing at rates near the low end of the long-term trend. That suggests a relatively slow pace of real GDP growth, in the 2% to 2.5% region, which is what it has averaged since 2010.

Credit Growth and Nominal Gross Domestic Product (GDP)

Note: Nominal GDP is gross domestic product (GDP) figure that has not been adjusted for inflation.
Source: St. Louis Federal Reserve Bank Credit of All Commercial Banks (TOTBKCR), and Gross Domestic Product (GDP), percent change from year ago, seasonally adjusted. Data as of December 31, 2012.

• Jobs and Income. In the U.S., where 70% of GDP is attributable to consumer spending, we see jobs and income growth as important factors to watch. Since 2007, when job growth declined and median household incomes flattened, consumer spending has slowed to an average annual growth rate of 1.9% compared to a 3.5% annual pace for the 25 years prior to the financial crisis. We are watching for unemployment to fall to a level where average hourly earnings and household incomes begin to rise again. Since the end of the recession in June 2009, job growth has been among the weakest of all post WWII recoveries. It could take more time.

Median Household Income in the U.S. 1984 to 2011

Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplements. Last revised on June 8, 2012.

• The Fed. Not surprisingly, the Federal Reserve’s policy of anchoring short-term interest rates at zero and buying long-term bonds is an important component of our interest rate outlook. Recent comments from some Fed officials indicating concerns about the long-term adverse affects of quantitative easing may be the first hint that policy will be changing. However, Fed Chairman Bernanke and Vice Chair Yellen, along with NY Fed President Dudley, all permanent voting members of the Federal Open Market Committee (FOMC), are still in favor of quantitative easing, and the majority of the committee has voted in favor of their policies since the financial crisis began. The Fed’s official stance is that they will continue quantitative easing until unemployment falls to 6.5% with inflation in the 2.0% to 2.5% range. We are listening for any shift in policy stance by Chairman Bernanke to signal a change in the interest rate outlook.
• Bottom line. We are still in the “lower for longer” camp but don’t expect to be there forever. We continue to favor a relatively cautious stance of reducing average duration to an intermediate-term range (5-10 year maturities, on average) based on our view that risk/reward for long-duration bond portfolios is unattractive.

What Drives the Corporate Credit Market?

Investment grade corporate bonds have benefited over the past four years from declining bond yields and tightening of spreads to Treasuries. High prices and falling average coupons may make it difficult to repeat the strong returns that corporate bonds have generated over the past few years. But it seems that the risk of rising interest rates—not just on corporate bonds, but most fixed income investments—has been on everyone’s minds lately. We’ll discuss how corporate bonds have tended to react in rising rate environments, and some points to consider when holding, or adding to, corporate bond positions.

• What drives corporate bond performance? Investors often discuss “the bond market” and the risk that rising interest rates have on bond prices. But there is no one “bond market”—not all bonds are the same and there can be various reactions to rising rates. Corporate bond yields include a credit spread, which is additional yield above a Treasury with a comparable maturity, to compensate for the risks holding a corporate bond, such as the risk of default. So evaluating corporate bonds means looking at both Treasury yields as well as the potential for changes in the additional yield received from a corporate versus Treasury bond.
• Credit spreads tend to fluctuate based on market conditions. Credit spreads can be thought of as compensation for taking on the credit risk of owning a corporate bond. Spreads tend to fluctuate based on a number of factors, including the outlook for economic growth. If economic growth is expected to be strong, investors may be willing to accept a lower credit spread since the risk of default may be lower. If growth is expected to slow, the opposite may occur.
• Rising interest rates have tended to lead to tighter credit spreads in the past. We think that any significant rise in rates will be the result of a stronger economy, which may lead to tighter credit spreads. This can help offset the risks that rising rates have on the price of fixed coupon bonds. If Treasury yields rise by 20 basis points, for example, but credit spreads decline by 20 basis points, the result would be no change in yield for corporate bonds, all else equal. While Treasury bond prices would fall, corporate bond prices may not since their yields remained constant. Looking at the table below, we see that recent periods of rising rates have led to lower spreads. We would point out that rising Treasury yields can, and often do, lead to negative total returns for investment grade corporate bonds, but it can lead to outperformance relative to securities that don’t have credit spreads.

Over the Past 10 Years, Rising Bond Yields Have Typically Been Accompanied by Tighter Credit Spreads

Note: Excess Return is the curve-adjusted excess return of a given index relative to a term structure -matched position in Treasuries. The calculation method depends on the index type. A portfolio, for example, may have an excess return above the index on which it is based. It is important to note that receiving an excess return almost always requires one to take on more risk.
Source: Barclays, Bloomberg and the Schwab Center for Financial Research. 10-year Treasury yield represented by the U.S. Generic Govt 10 Year Yield Index (USGG10YR). The corporate sector is represented by the Barclays U.S. Corporate Bond Index. Past performance does not guarantee future results.

• Credit spreads are at their long-term average. But corporate fundamentals overall remain strong and default rates remain low, so we think there could be room for spreads to decline. In fact, the speculative grade default rate, according to Moody’s, has come down since the highs reached during the financial crisis and has been under the 20-year average for the past two and a half years. The spread of the Barclay’s U.S. Corporate Bond Index is roughly 1.4%, or 140 basis points. Although we don’t think they will approach their all-time low of 51 basis points anytime soon, there is room for compression.
• The Bottom line. We think that tighter credit spreads could help offset some of the interest rate risk in corporate bonds if Treasury rates rise. But investment grade corporate bonds can still generate negative total returns in a rising interest rate environment. This don’t necessarily mean corporate bond investors need to rush for the exits, but we think it’s important to know how various asset classes may react, and try to be positioned accordingly.

Sequestration’s Impact on Muni Markets

A “new era” of federal austerity has arrived, as Congress debates spending cuts and allows sequestration—a series of across-the-board automatic spending cuts—to go into effect. Federal budget reductions will be a part of both the short- and longer-term revenue climate for municipal governments, in our view, whether sequestration takes effect in its current form or renegotiated into a series of more targeted reductions. For investors in muni bonds, here are some points to consider.

• Federal money makes up 34% of total state spending, according to the National Conference of State Legislatures. This seems like a large proportion of state budgets, but the money is spread out widely across a mix of mandatory and discretionary programs. Medicaid is one large federal program where there is a significant cross-over with state spending. Medicaid has been explicitly exempted from sequestration, however, lessening the potential impact on state budgets.
• The impact by region and state will vary. The importance of federal grants by state varies, however, as does the potential impact of reduced federal spending in individual states and municipalities. The Pew Center on the States has published a useful interactive map estimating grants subject to sequester, by state, as a percent of revenue. The sequester may also be temporary, replaced by a long-term package of more targeted budget cuts.
• Reduced federal spending will be a drag on economic growth in the short-term, in our view. Federal employment drives 5% of economic activity nationally, according to the Pew Center Data. But in D.C. and surrounding areas, it drives 20% or more of local employment. Lower federal spending will also likely reduce national GDP growth in the short-term, in the consensus view of economists, leading to lower rates for longer from the Federal Reserve, transferring through to rates on other investments including muni bonds.
• Moody’s outlook is negative on 4 Aaa-rated states and 40 local governments based on links to the federal government. Moody’s rationale for these negative outlooks relates more to their assessment of the connection between these governments and the credit quality of the U.S. government, not directly to sequestration, according to Moody’s commentary. If the U.S. Aaa rating is lowered, the ratings on these states and municipalities could be lowered also. States with Aaa ratings but negative outlooks include Maryland, Missouri, New Mexico and Virginia.
• Standard & Poor’s has said that they expect the impact to be “uneven” across sector. Each government will manage this “new era” of reduced federal funding differently, in their view, just as they adjusted to 2008/09 recession and other threats to credit quality. They anticipate that the effects of sequestration will be “mildly negative in broad terms,” with potential for more impact in specific credits or jurisdictions. But “with only a few high profile exceptions,” state and local governments have made cuts to preserve credit quality.
• Sector views. Local municipalities and school districts may face decreased federal grant funding for education programs and public safety. Airports and ports may face operational cuts and layoffs. Essential-service infrastructure providers, such as water and sewer systems, generally rely on user charges than federal funds for operations, so they may be less impacted. Medicare reimbursements to doctors and hospital will be reduced 2%, potentially impacting not-for-profit hospitals. Issuers in the higher-education sector may face reduced grant funding, though most are not reliant on these funds for debt service payments or operations.
• Bottom line. Despite of threat of less support from the federal government, most states, municipalities, and other issuers in the muni market will adjust to the “new era” of reduced federal spending, in our view. The impact is another bump in the road for municipal issuers. But we don’t suggest a change in strategy for investors holding well-diversified muni portfolios at this time.

Short-Term Bonds If You Think Rates Will Rise

The most common question we hear from investors is the risk to bond investments if interest rates rise. The second most common question is will bond returns keep up if we see inflation down the road. Repeating a theme, it depends on bonds you hold, in our view. An allocation to short-term bonds—meaning bonds or bond funds with shorter maturities—make sense to us if you worry about if and when rates rise—or if we see higher inflation longer-term. Here are our thoughts to explain our view.

• The value of short-term bonds or bond funds is less sensitive to the risk that rates rise. Two factors tend to matter most when looking at risk in bonds: the level of credit risk (the risk of not getting repaid) and the level of interest rate risk (how long it takes to be repaid). The shorter the maturity of a bond or the average maturity of bonds in a bond fund, generally the lower the interest rate risk, all else being equal. Short-term bonds or funds—which we define as having a single (or average) maturities between 1-5 years—are generally less sensitive than intermediate or long-term bonds, for shorter periods of time, if rates rise.
• Short-term bonds can be reinvested more quickly than long-term bonds. As a result, investors should be able to take advantage of the higher rates more quickly. For income-oriented investors, it may be helpful to have some money available and ready to reinvest when rates are more attractive. A short-term bond ladder with maturities from 1-5 years or a short-term bond fund can meet this objective.
• The Fed will likely increase short-term interest rates if inflation rises above 2.5%. The common wisdom says that short-term bonds will never keep up with inflation. That’s likely true over long time periods. But it may not be the case during periods when inflation rises quickly. If inflation rises at a rate above 2.0% to 2.5% annually, the Fed has said that it would raise short-term rates. In the late 1970s and early 1980s, when inflation (as measured by the year-over-year change in CPI) was rising rapidly, rates on cash investments and short-term bonds rose quickly, as shown in the chart below. Short-term rates fell in close relationship with inflation thereafter.

Rates on Cash Investments and Short-term Bonds: 1978-2013

Note: Yield to Worst is defined as the lowest potential yield that can be received on a bond without the issuer actually defaulting.
Source: Bureau of Labor Statistics, Bloomberg, and Federal Reserve. Data as of March 1, 2013.

• Keep an eye on duration—or average maturity. Duration is a way to measure, and monitor, interest rate risk, and is generally related to the bond’s time to maturity. A rule of thumb is that an existing bond or fund would be expected to fall in value by the duration multiplied by the change in interest rates. A bond (or fund) with a duration of 5 might fall 5% in value if interest rates rose 1%. Schwab clients can look at the distribution of maturities, which is generally slightly longer than duration, of their fixed income portfolios by logging in to Schwab.com, then navigate to Guidance > Tools > Portfolio Checkup. Then click on the Fixed Income tab. For the duration of an individual bond or bond fund, talk with as Schwab Fixed Income Specialist at 877-563-7818.
• We suggest a mix of short-term and intermediate-term bonds or funds. A bond ladder mixes bonds maturing soon with some maturing later. We prefer ladders with maturities maxing out at about 10 years, for most investors. For investors who prefer bond funds, consider a mix of funds that fall into Morningstar’s “short-term bond” category for shorter term needs (money needed within 1-5 years) combined with “intermediate-term bond” funds for higher potential income earned on principal that isn’t needed soon.
• Bottom line. Risk in the bond market depends on where you invest. For investors worried about rising interest rates and/or inflation, short-term bonds or bond funds may fall in value if rates rise. But they are generally less sensitive to interest rate risk, for a shorter period of time, than longer-term bonds, all else being equal. For this reason, they should play a part in your bond strategy, in our view, in a low rate environment.

Tags: Bonds, Kathy Jones, Schwab
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The Economy and Bond Market Radar (February 18, 2013)

Saturday, February 16th, 2013

The Economy and Bond Market Radar (February 18, 2013)

Treasury bond yields rose modestly this week as economic news was more or less in line with expectations. Positive sentiment regarding the direction of the economy continued. Eurozone GDP slumped 0.6 percent in the fourth quarter which was below expectations and potentially puts pressure on the European Central Bank (ECB) to act. Over the past week or so, there has been a lot of chatter surrounding the strength of the euro and if the ECB were to act to shore up the domestic economy, a side benefit may be a weaker and more competitive global currency.

Strengths

• The National Association of Realtors reported that home prices rose 10 percent in 2012. That was the biggest increase in seven years and indicates a recovering economy.
• January retail sales rose 0.1 percent, which matched expectations but was viewed positively in light of the payroll tax increase that took effect at the beginning of the year.
• The University of Michigan Confidence Index rose more than expected in the preliminary February release.

Weaknesses

• As mentioned above, eurozone GDP contracted during the fourth quarter, extending its recession.
• Industrial production fell 0.1 percent in January in a surprisingly weak start to the year.
• Inflation data in the United Kingdom, India and Brazil are showing signs of acceleration or maintaining relatively elevated levels.

Opportunity

• While some Fed members expressed concerns over continued quantitative easing, the Fed still remains committed to an extremely accommodative policy until the economy improves.
• Globally, central banks are increasing their stimulative policies, with Japan’s recently elected prime minister vowing to take on deflation and deflating the yen.

Threat

• The economy appears to be gaining momentum and bonds have sold off. The risk for bondholders is that this trend continues.
• Inflation in some corners of the globe is getting the attention of policy makers and may be an early indicator for the rest of the world.

Tags: Bonds, Economy
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