Historically, healthcare organizations have covered their cost of debt by investing in a conservative mix of fixed income securities. However, for most of the recovery since the Great Recession, the yield on their debt payments exceeded the Bloomberg Barclays Aggregate (Agg) bond index yield. Therefore, many organizations were forced to consider riskier assets to cover their debt payments as a result of this adverse spread. Now that the Federal Reserve rate hikes are underway, Agg yields are once again approaching parity with healthcare issuer debt yields and thereby reducing the pressure to invest in riskier assets to make up for the spread disparity.
Author: cvernon
The Market’s Bad Breadth
While many are familiar with technical analysis and its claimed prophetic approach to the markets using historical performance, this week we look at a derivative of the 50-day moving average through the lens of breadth.
Crossing below the 50-day moving average is considered a point of weakness whereas crossing above this trendline is viewed as a sign of future strength and bullish activity for the market or index in question. While the broad market, as proxied by the Russell 3000, had a strong May and June and remained above this moving average, it found weakness in August and has been below this trendline for the past few weeks. Instead of just analyzing the index as whole, we examine the behavior at a component level through market breadth which is a ratio of stocks with increasing prices to those with falling prices. A derivative of this metric is charted below as a ratio of stocks above their 50-day moving averages over those below; a ratio above 1 is a positive indicator for the market as this means more stocks are above their short-term average than below and indicates substantial market breadth. This is a good sign for the market as it means the majority of index constituents are exhibiting strength as opposed to only a few mega-caps lifting up the market.
Recently, however, this ratio fell below 1 which means stocks falling in price outnumber those increasing in price. Less than 42% of stocks in the Russell 3000 universe are trading above their short-term moving average whereas back in July more than 70% were trading above their short-term averages. That the market is trading flat during this new trend means that the upward movement of only a few stocks relative to the universe is keeping the market flat; this does not make for a stable market. While these are only technical indicators and are not cause for extreme alarm, the general indication of these data points is that market stress in the near future would not be completely surprising.
The State of Real Estate: An Era of Normalization?
Core real estate investments have flourished since the financial crisis. Since delivering six consecutive double-digit annual returns through 2015, the NCREIF Open-end Diversified Core Equity Index (NFI-ODCE) returned a positive 8.8% in 2016 and a positive 3.5% YTD through June 2017. While overall returns are moderating, the relatively lower high single-digit returns remain consistent with our longer term expectations for the asset class and real estate remains an attractive investment relative to other assets classes. Investors may be wondering how much longer the real estate cycle can continue and if it is time to pull back on their allocations. In this newsletter, we address these questions by examining critical drivers of the real estate market, including performance, valuation, leverage, income, and capital flows.
Don’t You Know, We’re Talking About An Evolution? Addressing The New Challenges Facing The Diverse Manager Community
In recent years, some proactive and thoughtful pieces have spurred constructive dialogue within the investment consulting and plan sponsor communities on the measurable benefits of incorporating “diverse” investment firms within their various investment programs. In short, a diverse investment manager can be defined as a firm that is women owned, minority owned, or a combination of the two.
This newsletter strives to enhance the ongoing series of constructive discussions and solutions featuring Marquette, the diverse investment manager community, and the plan sponsors who wish to advance diverse manager initiatives. It is Marquette’s view that broader conversations about the diverse manager community should deliberately acknowledge the existence of newer structural headwinds that diverse managers face in today’s market. By focusing on these material hurdles – some of which are highlighted in this newsletter – the plan sponsor, diverse manager and consultant communities will be in a stronger position to formulate practical solutions to these challenges.
The Re-Price is Right
Bank loans provide investors with many advantages, chief among them a floating rate feature that resets on a quarterly basis, benefiting the investor as interest rates rise. They also offer a senior secured top-of-an-issuer’s-capital-structure positioning, meaning that the bank loan investor has first-in-line access to the issuer’s assets should something go wrong. However, recent market dynamics have produced a phenomenon that cuts into bank loans’ attractiveness: re-pricings. A re-pricing is a renegotiation performed by the bank loan issuer with its bank loan investors. Typically occurring in rising rate periods, the re-pricing lets the bank loan issuer reduce the spread that makes up the total coupon it has to pay under its bank loan agreement. An example representative of several recent re-pricings is shown in this week’s chart.
The chart shows two time periods: one year ago (before re-pricing), on the left, and today (after re-pricing), on the right. One year ago, LIBOR, the base rate, was at 1.0%. The spread was 4.0%, making the total coupon, or yield, 5.0%. After the re-pricing on the right, as LIBOR increased from 1.0% to 1.5%–a direct result of the Federal Reserve’s recent rate hikes–the issuer has successfully renegotiated the spread from 4.0% to 3.5%. The total yield then remains at 5.0%. Bank loan issuers get to re-price only if the price of their bank loan exceeds par value, typically 101, and they can initiate re-pricings only after the non-call period ends, which typically lasts six to twelve months after issuance. High yield bonds, on the other hand, have much longer non-call periods, typically five years.
Currently, we are seeing large amounts of bank loan re-pricings. This is because of strong demand for bank loans, including re-priced bank loans, and a lack of supply in the form of new issuance due to low mergers and acquisitions activity, as the issuance of new bank loans is typically how an acquirer finances a take-over. Investors currently have an appetite for re-priced bank loans that is keeping the total yield after the re-pricing approximately equal to the total yield before the re-pricing. This phenomenon explains why bank loan spreads have remained close to their long term averages, as investors have not completely rushed into bank loans, which would have made spreads much tighter. We continue to recommend bank loans as a short-term and long-term allocation due to their moderate spread level, relatively strong yield (currently averaging 5.0%), and the aforementioned floating rate and senior secured features. As M&A activity picks up, we expect more new bank loan issuance, which would reduce the proportion of re-priced loans in the market, thereby raising overall yields on bank loan investment portfolios.
EM and Max Draw Down
Through the end of May, the MSCI Emerging Markets Index has returned 17.3% year-to-date and 27.4% over the trailing 12-months. This asset class has benefitted from improvements in the macro-economic environment that took place in 2016: stronger commodity prices, more stable currencies, and a better global economic growth outlook. With this change in backdrop, broad company fundamentals have improved including earnings growth and corporate profitability (as measured by ROE). Markets have taken notice and investor sentiment has shifted, resulting in positive fund flows into the asset class.
With all these good vibes in mind, this week’s chart looks at the annual max drawdown of the MSCI Emerging Markets Index. For every calendar year, even those with very strong returns, the index has experienced a double digit max drawdown. For example, in 2006, the max drawdown was 24%, but the calendar year ended with a 32% gain. Thus far, the max drawdown in 2017 is just 3%. Based on history, investors should not be surprised to see a double digit pullback in EM this year. Even if that occurs, a strong 2017 return is possible, as these types of swings have been par for the course in this asset class.
High Yield Position Paper
Originally released in June 2011, this update to our position paper clarifies the myths about the asset class, and sheds light on the benefits and risks of high yield bonds.
The paper examines the history of high yield bond issuance, features of high yield bonds and their indices, their risks and characteristics, high yield historical returns and correlations, and how to invest in high yield bonds including relative valuation and manager selection.
A Car Wash for Brazil?
Many EMD strategies hold overweight positions to Brazilian sovereign and corporate bonds, in both hard and local currencies. These overweight positions have rewarded investors over the past year as Brazil led the overall emerging markets debt (EMD) space in spread tightening, helping drive double-digit returns for the asset class. This was primarily due to renewed optimism after the impeachment of former Brazilian President Dilma Rousseff.
However, the possibility of two presidential impeachments in Brazil within a year has arisen over the last few weeks as news circulated that the Chairman of the world’s largest meat company has taped conversations of new Brazilian President Michel Temer discussing bribes related to Operation Car Wash. Operation Car Wash involves officials at Petrobras, Brazil’s main semi-public petroleum company, allegedly taking bribes for awarding contracts to construction companies at inflated prices. Temer denies any wrongdoing.
At least temporarily, this latest controversy threatened to derail the positive momentum from Brazilian bonds. As shown in this week’s chart, spreads spiked during the news broadcast of Temer’s allegations, but have retreated back to the previous tights of earlier this year as the market is apparently confident that Brazil’s economy can sustain another impeachment or that impeachment is unlikely. Of course, all EMD asset managers will continue to assess and adjust their positioning based on their interpretations of fundamentals, value and technicals. In spite of this recent news from Brazil, we recommend maintaining EMD holdings for the time being.
What’s Realistic for GDP?
Though GDP growth varies greatly throughout an economic cycle, the last several decades have seen it slowly decline. One of the many promises made by Trump and other presidential candidates during the election was to restore GDP to its higher levels once again. But even with beneficial policy changes, is it possible to achieve 3%-4% year-over-year growth?
GDP growth essentially comes from two areas: an increase in the number of workers or an improvement in output per worker. Output per worker, or productivity, generally comes from businesses investing in technology and equipment to improve efficiency. In this week’s chart, we’ve estimated this by taking the difference between growth in GDP and total workers. As the chart shows, productivity gained very little the last several years as most of GDP’s growth came from an improvement in the employment situation. The exception to this came during the financial crisis when employers tried to cut costs and become leaner. It seems after this there has been little room for businesses to become more efficient.
What makes this concerning is that the growth seen in employment is not sustainable. With the unemployment rate at about 4.5%, we are either at or nearing full employment, meaning that any growth in workers has to come from people joining the worker force. However, the opposite is expected over the next 10 years as baby bombers continue to retire. This suggests that productivity will have to improve just to maintain the current growth rate of the economy. While things like tax reform and infrastructure spending should boost growth, it seems unlikely that GDP will return to more historic levels any time soon.
The Fiduciary Duties of 457(b) Defined Contribution Plan Sponsors
This article offers governance best practices for public sector plan sponsors to consider. The fiduciary duties imposed on state and local government employers come from each state’s own laws, whether they be state constitutional law, state statutory law that has been enacted by each state’s legislative bodies, or common law, which is based on precedents from the body of judicial decisions.