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

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.

With the August 2nd deadline fast approaching investors are increasingly wondering whether the U.S. might actually default on its debt obligations. In an effort to gain some insight into what the market is expecting, this chart looks at the pricing of Credit Default Swaps (CDS) on U.S. Government debt over the last year. CDS only pay off in the event of a default and are often used by bondholders to hedge against the risk that a bond in their portfolios defaults. As a result rising CDS prices offer a good indication that the market expects a higher probability of default. What is most notable is the jump in CDS prices on 1 Year Treasuries, while at the same time, CDS on 5 and 10 Year Treasuries remain largely unchanged. Given the jump in CDS on shorter duration Treasuries the market seems to be indicating that, if there is a default, it is likely to occur in the next year. However, the lack of movement in CDS prices for 5 and 10 Year Treasuries indicates that the markets are assigning little overall risk of a default (because if a default occurred all Treasury bonds would suffer losses so we would expect to see a jump in spreads for CDS of all maturities). Lastly, to put these numbers in perspective, CDS on 5 year Greek debt trades at 2,320, CDS on 5 year French debt trades at 107, and United Kingdom debt trades at 75. So while there is considerable amount of concern over the debt ceiling deadline in Washington, the markets appear to be pricing in little risk of default.

As many commentators have pointed out, over the past two years the BarCap Aggregate has seen a large increase in its benchmark allocation to treasuries. Since December 2008, treasuries as a percentage of the Agg have grown from 21% to 33% (see first image above – click on thumbnail for larger version). This highlights a drawback of any bond benchmark based on issuance. Issuance based benchmarks by their nature drive allocations not based on expected risk and return, but based on the funding needs of underlying issuers. One of the primary drivers of the increase in treasuries as a percentage of the Agg has been the large federal deficits caused by the 2008 recession necessitating higher treasury issuance. Historical and projected deficits are shown in the second image above (click thumbnail for larger version).

The federal deficit picture shows why the Treasury component of the Agg may stabilize, albeit at a higher level. While the Federal budget remains challenged and the political environment uncertain, through GDP growth alone the Federal deficit will decrease from its peak.

A more important concern for investors is how the change in the composition of the Agg affects the risk and return profile of their fixed income portfolios. If treasuries increased in market weighting in the Agg, clearly other sectors decreased in weighting. The change in sector weighting in the Agg for major sectors is shown below:

Source: Barcap; changes since December 2008

As treasuries have increased as a percentage of the Agg, MBS, agency bonds, and securitized products (ABS and CMBS) have decreased. This is due to a combination of decreases in issuance, especially for securitized products, and Fed purchases (MBS). Notably, the percentage weight to corporate bonds has remained constant on relatively strong issuance, and the weight to credit as a whole has actually increased.

Over the past 10 years, treasuries have been highly correlated with agencies (0.96) and MBS (0.85), and had a lower correlation with credit (0.62). Returns and standard deviations for the past ten years are shown below: