Category: Chart of the Week

Defaults Set to Rise?

As shown in the graph above, 2013 has been a tremendous year for both investment grade and below-investment grade companies to issue debt. Given the near record low levels of both interest rates and credit spreads, the amount of issuance has not been surprising.

As shown in the graph above, 2013 has been a tremendous year for both investment grade and below-investment grade companies to issue debt. Given the near-record low levels of both interest rates and credit spreads, the amount of issuance has not been surprising. However, one of these very metrics which has driven this supply serves as a key risk metric to watch in the coming year: credit spreads. Over the last 18 months, the option adjusted spreads (“OAS”) for investment grade debt rated AA, A, and BBB has fallen; the decline in the OAS for high yield is even more remarkable.

Certainly, these declines have benefitted credit investors, but their current low levels coupled with low default rates hints that there is only one direction for defaults and subsequent credit spread levels to go: up. While we have not yet seen alarm bells ringing for either of these items, they bear watching over the coming year.

Home Prices Rise But Are Still Below 2006 Peak

Our Chart of the Week looks at the S&P Case-Schiller 10-City Composite Index which is one of the best broad measures of housing prices in the U.S. This is a “drawdown” chart that looks at prices as a percentage of their prior peaks. When the lines on the chart are at 100%, prices are at a new all-time high.

Our Chart of the Week looks at the S&P Case-Schiller 10-City Composite Index which is one of the best broad measures of housing prices in the U.S. This is a “drawdown” chart that looks at prices as a percentage of their prior peaks. When the lines on the chart are at 100%, prices are at a new all-time high. The chart clearly shows the modest drop in housing prices that resulted from the early 1990’s recession and the severe drop in prices following the 2008 credit crisis. Over the last 24 months, home prices have started increasing again as the economy improved, employment picked up, and interest rates remained low. Nonetheless, broadly speaking, housing prices remain significantly below their prior peak in 2006. A few interesting things to note:

  •  The 10-City Composite Index fell 34% from a peak in April 2006 to a trough in January 2012. The index has subsequently increased 16% from those lows.
  • Las Vegas had the largest drop falling 62% from peak to trough. However, housing prices in Las Vegas have jumped 34% from the bottom. Las Vegas still remains the most depressed housing market where, even after the recent advance, prices are only about half of what they were at the peak.
  • Denver is the only major market that has returned to peak pricing levels. Boston has been the second most resilient market, where prices are only 10% below the prior peak.

The rebound in housing prices is providing a nice boost to U.S. GDP, employment, and the stock market. As housing prices rise, fewer homeowners are underwater on their mortgages (i.e., owing more on their mortgage than their home is worth) which improves consumer credit quality, leads to lower mortgage delinquencies, and gives homeowners more flexibility to refinance or sell their homes. All of these trends still appear to be in the early stages at this point. As long as interest rates stay low, we expect these trends to continue in the months ahead, providing a boost to the economy and the markets.

Queue Levels for Core Real Estate Managers

This week’s Chart of the Week examines queue levels of core real estate managers. Real estate’s recent performance along with its yield premium has led to increased investor interest, and consequently the formation of contribution queues. Contribution queues are the value of the cumulative dry-powder to put to work, i.e. what could potentially get called by managers in a quarter.

This week’s Chart of the Week examines queue levels of core real estate managers. Real estate’s recent performance along with its yield premium has led to increased investor interest, and consequently the formation of contribution queues. Contribution queues are the value of the cumulative dry-powder to put to work, i.e., what could potentially get called by managers in a quarter. If 100% of capital is called, the contribution queue is eliminated: prior quarter queue − capital called + new investor commitments = current quarter contribution queue.

Queue levels have to be monitored carefully because they could potentially dilute investment returns. The pressure to call capital and earn management fees might outweigh adhering to investment discipline or paying fair value for an asset. Additionally, the pressure to put money to work could lead to style drift by going outside of appropriate geographies or property types in order to increase fund size. If a significant queue exists for a particular manager, he/she may feel the pressure to put this money to work and overpay for an asset, as opposed to adhering to a more disciplined investment process. Such a practice is critical in today’s market: if one overpays in the beginning, an asset’s return potential is decreased.

Evaluating the last two years of data, the industry’s quarterly contribution queue has averaged $6.3B. For the last two years, the average queue into a fund has ranged from $292M to $426M, but two funds are driving an upward bias with these values. Excluding these two managers, the quarterly average queue into a fund has ranged from $84M to $184M. Most important to note is that queue levels have remained relatively stable as prices have rebounded. Overall, the steady level suggests that managers are remaining disciplined when completing transactions and not rushing to put money to work.

T-Bill Yields Spike After Government Shutdown

As the government shutdown enters its second week and a resolution to the upcoming breach of the debt ceiling on October 17 appears nowhere in sight, signs of concern are beginning to surface in the U.S. Treasury Bill market. As the chart shows, yields on T-Bills maturing between October 17 and November 14 have spiked significantly over the past week.

As the government shutdown enters its second week and a resolution to the upcoming breach of the debt ceiling on October 17 appears nowhere in sight, signs of concern are beginning to surface in the U.S. Treasury Bill market. As the chart shows, yields on T-Bills maturing between October 17 and November 14 have spiked significantly over the past week. After yielding an average of 0.01% without much volatility throughout the month of September, yields on T-Bills maturing around the expected breach of the debt ceiling have risen fairly significantly following the government shutdown that started on October 1.

To illustrate this, the yield on the T-Bill maturing on October 17 rose from 0.02% on September 30 to 0.14% on October 7. As the government shutdown dragged on and it became apparent that the political dysfunction that resulted in the government shutdown would likely spill over into the fight over raising the debt ceiling, yields started to spike even further, rising to 0.28% on October 8 and 0.38% on October 9. T-Bills maturing within four weeks of the October 17 debt ceiling breach have experienced a similar phenomenon. Interestingly enough, T-Bills maturing before October 17 and after November 14 have not seen any significant movement in yields, which indicates that while there is growing concern about a potential short term disruption to the U.S. Treasury market, the situation has not yet eroded investors’ confidence in the full faith and credit of the United States.

It is important to continue to monitor the recent rise in short-term T-Bills; if a similar spike in yields were to occur across the Treasury curve, it could have a significantly negative impact on the markets and the economy.

Income Drives Core Bond Returns

This week’s chart shows the since inception growth of a dollar in core bonds, represented by the BarCap Agg index from January 1976 through August 2013. The total return components, price return and income return, are broken out separately to highlight just how significant the coupon payment is for the performance of this index over time.

This week’s chart shows the since inception growth of a dollar in core bonds, represented by the BarCap Agg index, from January 1976 through August 2013. The total return components — price return and income return — are broken out separately to highlight just how significant the coupon payment is for the performance of this index over time. Since inception, approximately 85% of total return is attributable to the income component.

Given our current low rate environment and the future headwinds of rising interest rates, performance going forward is anticipated to be lower than what was achieved during the last 30 years, which was largely a falling interest rate environment. However, it is important to note that the income component will always yield a positive return, unlike price appreciation which will vary depending on interest rates. Principal repayment and the income from coupons represent a steady and consistent source of return for investors. This feature continues to make core bonds a sensible asset class for most institutional investors who want to maintain liquidity and principal protection in their portfolios.

Examining International Market Returns for U.S. Investors

This week’s COW looks at the year-to-date returns of the major international markets (Europe, Japan, and Emerging Markets) through September 25, 2013. This chart disaggregates the returns that U.S. investors have realized so far this year between the currency return and the local stock market performance

This week’s COW looks at the year-to-date returns of the major international markets (Europe, Japan, and Emerging Markets) through September 25, 2013. This chart disaggregates the returns that U.S. investors have realized so far this year between the currency return and the local stock market performance. While the depreciation of the Yen has helped drive the Japanese stock market to levels not seen since the late 1980’s, U.S. investors have only partially benefitted from the strong Japanese equity returns because of the fall in the Yen relative to the U.S. dollar. Interestingly, weak emerging market currencies were a theme for most of 2013, but with the Fed’s recent decision not to start tapering their quantitative easing (QE) program in September, emerging market currencies and equities have rallied significantly, pulling the year-to-date U.S. investor return close to even.

Continued QE and the Fed’s Balance Sheet

Since 2008, the Federal Reserve has embarked upon an unprecedented effort to stabilize and support the national economy in the aftermath of the 2008 financial crisis. At first, the effort was more of an emergency response, aimed at stemming the worst economic calamity since the Great Depression. However, as the threat of a systematic meltdown subsided, the Fed’s focus shifted to ongoing support aimed at restoring economic health

Since 2008, the Federal Reserve has embarked upon an unprecedented effort to stabilize and support the national economy in the aftermath of the 2008 Financial Crisis. At first, the effort was more of an emergency response, aimed at stemming the worst economic calamity since the Great Depression. However, as the threat of a systematic meltdown subsided, the Fed’s focus shifted to ongoing support aimed at restoring economic health. Now, five years after the Global Financial Crisis, the recuperation continues. While the economy has been pulled from recession and is proceeding on the path to recovery, unemployment remains stubbornly high and overall growth is lackluster.

As a result, the Fed announced Wednesday that the third round of quantitative easing will continue as planned until economic data reflects a more robust recovery. The Fed will remain accommodative and continue to purchase $85 billion of Treasury and mortgage-backed securities on the open market per month. As the asset purchases continue indefinitely, the size of the Fed’s balance sheet, which has changed size and composition drastically since the crisis, will continue to expand. Going forward, we expect Wednesday’s announcement to support the ongoing bull market in the equity markets, but at the expense of bond yields, which will likely stay low until the Fed truly begins to taper its asset purchases.

Agg’s Stake in Treasuries Continues to Grow

This week’s chart shows the growth of Treasuries in the BarCap Agg index. As of June 30, 2013, U.S. Treasuries made up 37% of the Agg’s holdings, which is higher than it has been in previous years. In 2007, the Agg’s Treasury position was roughly 22% and in 2010, it moved up to 33%.

This week’s chart shows the growth of Treasuries in the BarCap Agg index. As of June 30, 2013, U.S. Treasuries made up 37% of the Agg’s holdings, which is higher than it has been in previous years. In 2007, the Agg’s Treasury position was roughly 22% and in 2010, it moved up to 33%.

Treasuries have been a growing piece of the Agg recently because the Agg is an issuance-based index. This means that areas of the market with more issuance will gain bigger positions in the index. The U.S. Treasury has been issuing more and more debt over the last few years to cover government shortfalls. As issuance has grown over time, Treasuries have taken up a larger piece of the index than previous years. Indeed, the Agg’s Treasury stake stayed in the mid-20 percent range for most of the 2000s until 2008, when the Fed’s quantitative easing (“QE”) program began. After that, the Treasury stake surged to the mid-30 percent range.

Investors should prepare for an even larger Treasury position in the Agg going forward. The Congressional Budget Office projects Treasury issuance to grow by an additional 68% over the next 10 years. With the taper of the Fed’s QE program looming and an expected rise in interest rates, an Agg that is even heavier in Treasuries is poised to struggle. Given this phenomena, investors should examine their fixed income portfolios and consider looking outside of core bonds for additional diversification and income sources.

The Current Yield Environment

The S&P 500 returned -3.1% excluding dividends for the month of August. As the bull market seems to be losing steam, institutional investors will likely see lower returns from equity markets. Further compounding future portfolio returns is that bond prices are likely to be hampered by the threat of rising interest rates.

The S&P 500 returned -3.1% excluding dividends for the month of August. As the bull market seems to be losing steam, institutional investors will likely see lower returns from equity markets. Further compounding future portfolio returns is that bond prices are likely to be hampered by the threat of rising interest rates. Looking forward, a larger portion of investors’ returns may rely on receiving income in the form of interest and dividends rather than price appreciation.

With that in mind, we focus this week’s chart on asset class yields. Although the 10-year Treasury yield rose sharply in the 2nd quarter, this rise did not represent a parallel shift of the yield curve: yields on the shorter end of the curve remain low. Consequently, traditional bond portfolios with lower duration are still faced with the challenge of low yields, and the yields-to-maturity of the U.S. and Global Aggregate Bond Indexes remain compressed at 2.48% and 2.14%, respectively. Looking purely at yield, we see that senior secured loans (as measured by the CSFB Leveraged Loan Index), real estate (NCREIF Property Index), emerging markets debt, and high yield bonds are all yielding more than double the core bond market. Additionally, senior secured loans and real estate, in particular, offer lower interest rate risk. As such, these asset classes continue to offer compelling diversification benefits as components of an institutional portfolio.

The Wage Gap Between the U.S. and China Continues to Narrow

This week’s Chart of the Week examines the differences in average wages in the United States and China. As China has experienced substantial economic growth, it has also seen its average yearly wage for employed people in urban units rise from ¥9,333 in 2000 to ¥41,799 in 2011.

This week’s Chart of the Week examines the difference in average wages in the United States and China. As China has experienced substantial economic growth, it has also seen its average yearly wage for employed people in urban units rise from ¥9,333 in 2000 to ¥41,799 in 2011 (most recently available data). When converted and normalized into 2011 U.S. dollars, this is an increase from $1,472 to $6,468, which constitutes a 14.6% compounded annual growth rate in real dollars. On the other hand the U.S., like most other developed countries, has experienced stagnant real wage growth, fluctuating between $41K and $44K over the past decade.

A significant difference between the two wage levels remains with the average wage in the U.S. almost seven times higher than the average Chinese wage. However, many of the largest sectors of the Chinese economy are far more labor intensive and better represented by the U.S. minimum wage. The current minimum wage in the U.S. is $7.25/hr or $14,500 annually. Assuming there is no change in the U.S. real minimum wage, the Chinese average wage is on pace to surpass this in 2017.

While China has often been a cheap source of labor for businesses, wage increases could hurt the competitiveness of firms located in China. If Chinese wage growth continues on the current trend companies may decide that it is no longer optimal to produce in China. The effect this would have is twofold. As businesses leave China, the growth in the Chinese economy could slow. Secondly, this could lead to more jobs returning to the U.S., lowering unemployment and increasing wages.