Topic Tags: Fixed Income - Emerging Markets

Lower Debt Costs in Eurozone

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens.

This week’s chart examines the improving financial conditions in the Eurozone’s peripheral countries. Italy, Spain, and Portugal have recently seen their borrowing costs reach significant lows as investors’ confidence strengthens. Italian and Spanish 10-Year bond yields fell to 3.1% in late April, the lowest since 1999 for Italy and 2005 for Spain. After its first regular debt auction since a 2011 bailout, Portugal saw its yields drop to 3.7% marking a new post-2009 low.

More than two years removed from the European debt crisis, investor sentiment has improved as economic growth (though small) has returned to the region with participation from the peripherals. The Eurozone’s purchasing managers composite index (PMI) has been in expansion territory for nine consecutive months and hit a post-crisis high of 54 in April. While the Eurozone certainly remains in a fragile state with only a tepid level of growth, investors are encouraged by the improving conditions as well as the commitment of additional support from the European Central Bank if needed.

Emerging Market Debt

This paper explores EMD as an asset class, focusing on the benefits and risks. Further, EMD characteristics and their impact on portfolio dynamics are discussed. Recommendations as well as guidance toward making an allocation to the asset class are included.

Due to risks, uncertainty, and overall lack of credit quality, institutional investors have not historically included emerging market debt (“EMD”) in their portfolios. However, the investment landscaped has changed over the past few years. Driven by low interest rates and deteriorating fundamentals in the United States and other developed countries, investors’ interest in EMD has skyrocketed in recent years.

This paper explores EMD as an asset class, focusing on the benefits and risks. Further, EMD characteristics and their impact on portfolio dynamics are discussed. Recommendations, as well as guidance toward making an allocation to the asset class, are included.

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Emerging Markets: A Crisis of Confidence

February 2014 Investment Perspectives

After a disappointing 2013 and a significant sell-off to begin 2014, many investors are questioning their ongoing allocations to emerging markets (“EM”). Since 2013, EM countries have consistently underperformed their developed market counterparts, with equities losing 8.8% and local currency debt declining 12.5%. This compares to the S&P 500 and the EAFE which have returned 27.2% and 20.1%, respectively, over the same time period.

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A Challenging Year for Core Bonds

This week’s chart depicts the challenging environment core fixed income investors faced in 2013. The ten-year Treasury rate jumped causing significant price depreciation while the coupons failed to cover the losses.

This week’s chart depicts the challenging environment core fixed income investors faced in 2013. The ten-year Treasury rate jumped causing significant price depreciation while the coupons failed to cover the losses. The Barclays Agg index declined 2.0% in 2013, the first negative calendar year return since 1999. This performance was made up of a -4.6% price return and a 2.6% coupon return.

Facing the prospects of low income and prices losses, many investors transitioned away from traditional core bonds in favor of higher yields and/or lower interest rate risk. It should be noted that this allocation change generally accompanies an increase in credit risk as there is no free lunch. While the bull market in fixed income is likely over and return expectations have been lowered, traditional bonds still serve an important role as an anchor to diversified portfolios, providing a steady source of income and principal repayment to investors.

Fixed Income Repositioning

This week’s Chart of the Week examines the estimated net mutual fund flows that occurred within fixed income from January 2013 through November 2013. Notable fund flow trends during this time included investors diversifying away from more traditional bond categories such as intermediate-term, municipal, government, inflation-protected bonds, and money markets.

This week’s Chart of the Week examines the estimated net mutual fund flows that occurred within fixed income from January 2013 through November 2013. Notable fund flow trends during this time included investors diversifying away from more traditional bond categories such as intermediate-term, municipal, government, inflation-protected bonds, and money markets. With generally low yield levels across fixed income asset classes and the expectation of a rising interest rate environment, investors added to categories such as bank loans, nontraditional bonds (which include unconstrained and opportunistic categories), world bonds, and short-term bonds.

Favored bond categories in 2013 tended to carry less interest rate risk such as bank loans and shorter maturity securities. Tactical investments like nontraditional bond and world bond categories where the investment manager typically has more control over interest rate or credit exposures taken at any given time also drew investment dollars. Short and ultra-short bonds were favored as a substitute for money market funds in the current low yield environment.

As investors reposition their fixed income portfolios for an expected low growth and rising interest rate environment, strategies with low interest rate risk or an emphasis on tactical flexibility within their mandates will likely continue to see net positive fund flows.

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.

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.

Banking on Bank Loans

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 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!

Warning Signs From the Bond Market?

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.

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.