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.

This week we look at the historic net asset flows for bank loans courtesy of Morningstar’s Asset Flows report. February 2013 saw the largest ever monthly net asset inflow for bank loan mutual funds and ETFs. This tops the previous best, January 2011, by 14%. Investors undoubtedly have been attracted to spreads well above the historic median.

In late 2011 with historically wide spreads, high yield experienced its largest net asset inflows and carried that momentum into the following year. Investors were paid off with double digit returns in 2012. Based on net asset flow data, investors are now banking on bank loans to produce strong returns in 2013. Net flows have been positive for eight straight months including the February high. Of course, investments can quickly change course as seen in 2011. The previous largest net inflow for bank loans occurred in January 2011 and was followed by the largest net outflow seven months later leading to disappointing returns that year. Thus while valuations appear compelling and fund flows have been positive, just like anything when it comes to investments, positive returns are not guaranteed!

Viewed by many on Wall Street as the “smart money,” the bond market often serves as a leading indicator for the stock market in search of future direction. In 2007, it was the bond market that was first to flash warning signs of a looming crisis as stocks continued their steady upward march. Investment grade corporate spreads reached their tightest point of 82 basis points in late February 2007. By the time the S&P 500 peaked later that year in October, corporate spreads had widened out to nearly 140 basis points. As the crisis bottomed in early 2009, it was again the bond market that was first to reverse course. Corporate spreads reached their widest point in early December 2008 and it wasn’t until March 2009 that the stock market found a bottom.

As equities have once again approached their all time highs, the bond market may serve as a useful reference for investors looking to the future. Corporate spreads tightened to the mid 130’s at the beginning of January 2013 and have remained there while stocks continue to rise. Although there is room for spreads to tighten further before reaching the lows set during previous peaks in the equity markets, any dramatic reversal in equity prices will likely be preceded by their bond counterparts.

This week we look at the historic three year discount margin for bank loans. Bank loans provide a source of financing for public and private corporations as well as private equity firms. They are a floating rate debt obligation generally linked to LIBOR and typically callable with few or no penalties. In comparison to investment grade bonds, bank loans have higher credit and liquidity risk, but lower interest rate risk. In a low rate environment, floating coupons can be attractive to investors.

In 2008 and 2009 liquidity issues caused bank loan prices to drop drastically. This can be seen in the chart, as the price drop drove the three year discount margin to all time highs. Since then, liquidity has improved and the discount margin has come down. In 2012 we saw the discount margin fall from 656 bp to 555 bp. Even with the pronounced decline from 2009, discount margins are still above the long term median of 387 bp. This spread appears to be an enticing option for investors looking to decrease interest rate risk. The discount margin also compares favorably with high yield bonds, and based on early data, institutional investors have begun to swap high yield investments for bank loans.

The chart above depicts the amount of Italian government bonds held by Italian banks. As seen in the chart, this amount hovered between $200 and $250 billion until December of 2011, which is when the first round of the Long-Term Refinancing Operation (LTRO) began. A notable aspect of the LTRO was that it allowed Italian banks to borrow funds from the ECB for 3 years at a 1% interest rate with appropriate collateral. Given these favorable terms, Italian banks used portions of the funds obtained from the ECB to invest in higher yielding bonds issued by their government. As a result, the number of Italian bonds owned by Italian banks has since swelled to nearly $350 billion. Ultimately, this trend has been helpful to lower the interest rate on Italian bonds, but is troublesome since a large portion of the debt that Italy issued has been purchased by Italian banks because foreigners have been skittish to invest. Foreign investors have cut their holdings of Italian governments bonds to their lowest level since 2005. As Italian banks purchase more Italian government bonds, the public and private sectors become more intertwined.

Italy has a substantial portion of debt maturing in the next few months (table below). It remains to be seen if there will be sufficient demand (foreign and domestic) to refinance these obligations at a reasonable interest rate.

Italy – Principal Maturity

Month	Aug-12	Sep-12	Oct-12	Nov-12	Dec-12
Amt (Mil)	$30,663	$27,462	$36,751	$26,975	$53,718

 

ECB president Mario Draghi has indicated a willingness on behalf of the ECB to step in and purchase Italian bonds that fall on the short end of the yield curve to ensure liquidity. This implied guarantee means that Italy will most likely issue short term debt to attract investors. By issuing short-term debt, Italy essentially buys itself a little more time to demonstrate economic improvement to attract foreign investment. However, a lack of progress will likely translate into larger near-term debt and rising interest rates.

Most investors understand that over the long-term, the investment grade credit sector tends to outperform the U.S. government sector due to its risk. Many may be surprised however, at the size of the outperformance. Since its 1973 inception to May 2012, the BarCap U.S. Credit Index has outperformed the BarCap Government Index by just 38bps. Today’s Chart of the Week shows the rolling three year outperformance of the BarCap Credit Index versus the BarCap Government Index. Up until 2007, credit enjoyed a long period of relatively steady outperformance, interrupted by the recession after the tech bubble burst.

To achieve this outperformance, investors in credit would have experienced a standard deviation of 7.79%, compared to 5.61% for governments. The maximum decline for credit versus governments was -19.26%, and -7.92% respectively. This decline in credit was actually experienced from September 1979 to March of 1980, not in 2008.

Thus, while the credit crunch of 2008 was an extreme event, the actual margin of underperformance in credit had been seen before in the 1980’s. It is also important to note that the raw outperformance numbers are likely overstated in favor of the credit index, which has a longer duration. As rates have been in a secular downward trend over the past 30-years, this has boosted longer duration returns. The duration of the BarCap Credit Index as of May 31 was 6.73, compared to 5.43 for the BarCap Government Index. From 1997 to 2012, the period for which duration numbers are available, the credit index has had an average duration 0.91 higher than the government index.

Of course, past returns do not necessarily predict future returns. The forward outlook for credit has tended to be more positive during periods of elevated spreads, as investors are paid a higher premium to take on credit risk. As of the end of May, the option adjusted spread of the BarCap Credit Index was 193bps, compared to its long-term average of 121bps.

Much has been made of the low bond yields on risk-free U.S. government debt. The yield on 10-year government debt dropped to just 1.7% as of May 18th. Many investors assume that if rates stay where they are today bond returns will be less than 2% over the coming years. However, this ignores both the steepness of the yield curve and the fact that most institutional investors maintain a fairly constant duration in their bond portfolios. This chart shows the current yield curve (red line) and the expected return an investor can expect to achieve owning government bonds at each maturity along the curve, assuming they maintain a constant duration. As the chart shows, investors in 10-year bonds will earn almost double the 1.7% return indicated by the yield curve if rates remain unchanged.

While this may come as a surprise, the math is fairly straightforward. An investor that buys a 10-year U.S. government bond today will pay $100.47 and receive a $1.75 coupon. The 10-year risk free interest rate is 1.70% and the 9-year risk free rate is 1.51%. This means that one year from now our investor owns a 9-year bond that pays a $1.75 coupon. However, because the current market interest rate for a 9-year risk free bond is 1.51%, the bond has appreciated to $101.99. To maintain the duration of the investment, our investor sells the 9-year bond at $101.99 and buys a new 10-year bond. Since rates have not changed a 10-year bond still sells for $100.47. Our investor’s total return is thus:

($101.99+$1.75)/$100.47 = 3.25%

This simple illustration and the implications for an institutional portfolio are discussed in greater detail in Marquette’s April 2011 Investment Perspectives “Short Duration vs. Core Bonds in a Rising Rate Environment”. Currently, the yield curve is predicting a fairly substantial rise in interest rates a few years in the future. However, if such a rise does not materialize and the current low rate environment persists, bond returns may once again exceed expectations.

Wild uncertainty in the equity markets coupled with European debt concerns have driven U.S. Treasury yields to all-time lows, and left income-driven investors searching for alternative sources of yield. While bonds will always serve as a major component of an income-driven portfolio, the overarching low yield environment has led investors to look beyond the traditional sources of return. This week’s Chart of the Week examines the potential of other asset classes to provide the income streams that have historically been provided by bonds.

As shown above, dividend yields for U.S. large cap equities now exceed that of the 10-year Treasury, and the MSCI EAFE and EAFE Value indices have attractive yields as well, exceeding those of the BarCap Global Bond Index and the BarCap U.S. Corporate Bond Index. The NCREIF Property Index has generated an annual income return of 6.44% as of June, 30, 2011, which provides an opportunity for greater portfolio diversification with minimal correlation. These asset classes are more volatile than traditional bond portfolios in regards to capital appreciation, but the income generation has become favorable to many options in fixed income. While it would be premature to label these trends as a new regime, it will not be surprising to see income-driven investors tilt their portfolios to include greater allocations of higher yielding (and traditionally more volatile) asset classes.