Topic Tags: Fixed Income - Global

How to Position Fixed Income Portfolios for the Rate Hike

October 2015 Investment Perspectives

Much has been written and discussed in the media about when the rate hike will begin and the pace at which it will occur. Ultimately, the timing and pace are difficult to predict because they depend on many moving parts, including unemployment, inflation, and a host of unpredictable economic and political factors. The right question to ask is: How should an institutional investor position a fixed income portfolio for the rate hike, regardless of the associated timing and speed?

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Yield Compression in the Eurozone

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward-looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

On March 5th, Mario Draghi, President of the ECB, announced the details of the QE program and surprised markets by stating that purchases would include issues with maturities as far out as 30 years, causing a compression in yields (actual purchases by the ECB and various national banks began on March 9th). As the chart demonstrates, the largest yield compression has occurred in German bonds, where yields on 30-year maturities were 0.633% on Wednesday morning, down from 0.946% on March 5th. The spread between 2 and 30-year German bonds is currently 87 basis points. Yields for some of the riskiest longer-dated European debt (demonstrated here by Spanish and Italian bonds) have also seen compressions, though the spread between 2 and 30-year yields remains around 2%.

What does this mean for investors and the ECB bond buying program? Given the inverse relationship between bond yields and prices, the notable drop in yields has benefitted investors. However, reinvestment risk is a significant concern for investors should they sell their current holdings, as they would then have to purchase newer bonds that feature lower yields and coupons. Unless immediate cash is needed, bond investors will be loath to give up their higher yielding bonds in exchange for lower yields. Some wiggle room will be available as the front runners of QE look to cash in their profits, but others may hold out for a time since the ECB is a large, price indifferent buyer. Eventually, supply will normalize, possibly through a combination of profit taking and the ECB “nudging” those stubborn bondholders to sell.

2015 Market Preview

January 2015

Similar to previous years, we offer our annual market preview newsletter. Each year presents new challenges to our clients, and 2015 is no different: U.S. equities are at all-time highs, uncertainty reigns for international equities, and to everyone’s surprise, interest rates fell dramatically in 2014…but are poised to rise from historic lows over the next year. In the alternative space, real estate remains a solid contributor to portfolio returns, and private equity delivered on return expectations, though dry powder is on the rise. Hedge fund results were mixed, but have shown to add value in past rising interest rate environments. Further macroeconomic items that bear watching for their potential impact on capital markets include the precipitous fall in oil prices, the strengthening U.S. dollar, job growth, and international conflicts.

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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.

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!