Topic Tags: Fixed Income - Investment Grade

Diverging Market Opinions (aka The Bears vs The Bulls)

This week’s Chart of the Week examines a recent phenomenon seen in valuations for both bonds and equities. U.S. stock prices rose quickly over the last year and a half with the S&P 500’s P/E ratio climbing to 21.8, surpassing its 20 year average. Meanwhile the Bloomberg Barclays Aggregate Index saw its option adjusted spread (OAS) fall below its 20 year average to .43%. OAS is a primary metric for valuating bond prices and this tightening suggests that bond prices are relatively expensive.

This is a rare situation as it is counterintuitive for both indices to be valued highly at the same time. Highlighted in the gray bars on the chart are the months when this occurred. During the late 90s equity valuations hit historic highs with the tech bubble. Treasury rates during this time were as high as 7%, so even though spreads were low the total yield on the Agg was still relatively high. Today’s environment is much different with Treasury yields around 2%. Excluding a transitory period in 2003 this was the only other time when this happened.

What makes this so unusual is bond and equity prices typically move in opposite directions of each other. Stock valuations increase when investors are confident in the markets and want to take advantage of a strong economy. Bond prices typically rise during “risk off” periods when investors look to be more defensive. The fact that both are rising seems to suggest there is increasing polarization of opinions in the financial markets. Since there is so little precedence for this situation it is difficult to know what to expect, but something almost certainly will have to give. Only time will tell who will win: the bulls or the bears.

2017 Market Preview

January 2017

Similar to past market preview newsletters, we enter the year with a new set of questions. What shape will Trump’s policies take and how will they impact the market? Will the formal start of the Brexit have an impact on portfolios? To what degree and pace will the Fed increase interest rates? These topics among many others are covered in the following articles as we offer our annual market preview newsletter. Each year presents new challenges to our clients, and other headlines will emerge as the year goes on; it is critical to understand how asset classes will react to each new development and what such reactions will mean to investors. The following articles contain insightful analysis and key themes to monitor over the coming year, themes which will underlie the actual performance of the asset classes covered. Recognizing that many of our clients may not have time to cover the following 30 pages of material, we offer the primary conclusions for each asset class heading into 2017.

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2016 Asset Allocation Winners and Losers

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small caps were the outright winner with a 21% return. These smaller cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

January is a time to reflect on the past year and assess what went right and what went wrong, and asset allocation is no different in this regard. Elevated valuations at the start of 2016 did not hold back U.S. equities as they climbed to record highs; small-caps were the outright winner with a 21% return. These smaller-cap companies received a post-election boost as they were expected to be less affected by the strengthening dollar and potential trade policies enacted by Trump, since they do not typically conduct much international business. The knock-on benefits of a potential lower corporate tax rate also helped propel small-cap equities higher after the election.

Internationally, slowing growth concerns were a determinant of performance. The “anti-establishment” sentiment seen in Europe was a major source of uncertainty. Emerging markets were the most appealing in terms of relative valuations, which helped them deliver double-digit returns after three consecutive negative years.

Lastly, fixed income was led by high yield bonds which rallied back from an end-of-year dip in 2015, with lower quality issues leading the way. Long duration bonds were also a top performer within fixed income, as were bank loans. After the Trump victory revived inflation expectations, TIPS became a topic of discussion. Realistically, as policies will take time to implement, inflation will manifest slowly and will be only one of a few indicators to monitor.

Of course, 2016 is behind us and investors are at this point more interested in what the markets will bring us in 2017. While predicting market winners and losers each year is a difficult exercise, it is safe to say that we will not see a repeat of 2016 asset class performance, and maintaining a diversified portfolio with disciplined rebalancing will help to mitigate risk no matter what happens across the global markets.

What Does the Fed’s Rate Hike Mean for 2017?

December 2016

On December 14, 2016, the FOMC announced its unanimous decision to raise interest rates by 25 basis points, bringing the target fed funds rate to between 0.50% and 0.75%. This was the first increase since last December’s, with the hike prior to that occurring in 2006 before the Great Recession.

This move was widely anticipated and well-communicated to the markets. As such, fed funds futures carried a 100% implied probability of a hike going into it, and most – if not all – of the hike was already priced into global markets. Markets over the past one and a half days since the hike have remained relatively calm. The 10-year Treasury yield rose by only 12bp to end at 2.6%, while the one-year Treasury yield rose by just 3bp to end at 0.9% and the 30-year Treasury yield rose by 2bp to end at 3.1%. The Core Aggregate bond index and the Intermediate Government/Credit index were down only 0.5%, while the 1-3 Yr Government/Credit index fell 0.2%; the Long Government/Credit index also decreased 0.2%. The Credit Suisse Leveraged Loan index was up 0.1%, the Credit Suisse High Yield index was down 0.3%, and the JPMorgan emerging markets debt EMBI Global Diversified index decreased by less than 0.1%. The dollar rose while gold declined, as expected. The S&P 500 declined less than 0.1%.

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The Impact of Trump’s Victory on Capital Markets

November 2016

To the surprise of pollsters, analysts, and much of the American public, Republican presidential candidate Donald Trump trampled predictions by winning the presidential election in stunning fashion.

The long-term impact of Trump’s presidency on financial markets is impossible to predict at this point, given the amount of uncertainty around his expected policies. However, the short-term dynamics surrounding his election win are starting to emerge, and we share with you what we are seeing and hearing in the market in this newsletter.

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Is the Recent Spike in LIBOR a Cause for Concern?

This week’s chart of the week looks at the recent spike in the London Inter Bank Offered Rate (LIBOR), which is the rate at which banks charge one another for short term loans. As the chart illustrates, over the past year the 3-month LIBOR rate has increased from 0.32% to 0.88% (an increase of 0.56%), which is the highest rate for 3-month LIBOR since the spring of 2009. While other measures of short term interest rates – such as the Fed Funds Rate (increasing from 0.25% to 0.50%) and 3-month T-Bills (increasing from 0.01% to 0.33%) – have also risen over the past year, the magnitude of the LIBOR increase is significantly larger and warrants further examination.

This week’s chart of the week looks at the recent spike in the London Inter Bank Offered Rate (LIBOR), which is the rate at which banks charge one another for short-term loans. As the chart illustrates, over the past year the 3-month LIBOR rate has increased from 0.32% to 0.88% (an increase of 0.56%), which is the highest rate for 3-month LIBOR since the spring of 2009. While other measures of short term interest rates — such as the Fed Funds Rate (increasing from 0.25% to 0.50%) and 3-month T-Bills (increasing from 0.01% to 0.33%) — have also risen over the past year, the magnitude of the LIBOR increase is significantly larger and warrants further examination.

Over the past few months, both the Fed Funds Rate and T-Bills have remained flat, while LIBOR has continued to increase steadily (increasing from 0.65% on June 30th to 0.88% on September 18th). During this time period, the spread between LIBOR and T-Bills (known as the TED spread) has increased from 0.39% to 0.55%. In fact, the current spread of 0.55% is higher than the 0.42% average TED spread since the year 2000. This is concerning because historically, an increase in the TED spread has indicated stress in the financial markets. The TED spread spiked in mid-2007 when signs of the financial crisis first started to appear, and spiked again in 2008 as the crisis unfolded. Now that the TED spread is increasing again, there is some concern that this may be an early sign of another financial crisis starting to unfold.

In order to put the recent rise in LIBOR (and the corresponding rise in the TED spread) in context, it is important to look at what has driven these rates higher. Unlike the 2007/2008 financial crisis, the recent increase in LIBOR is not a result of distress in the credit markets. In fact, between June 30th and September 18th, high yield credit spreads (a reliable measure of the health of the credit markets) decreased by 1.4%. And unlike the 2007/2008 financial crisis, the recent increase in the TED spread has been relatively small. While the current 0.55% TED spread is slightly greater than the long-term average, it is well below the 4.63% peak we saw during the fourth quarter of 2008. The recent increase in LIBOR appears to be driven primarily by the money market reforms that went into effect on October 14th that require most money market funds to invest exclusively in U.S. government securities. As a result of this new regulation, more than $1 trillion has moved out of “prime” money market funds, which were allowed to invest in short-term corporate bonds and certificates of deposit tied to LIBOR rates, and into “government only” money market funds. It is unclear whether the increase in LIBOR rates and TED spreads are a temporary phenomenon driven by a supply/demand imbalance or if this is a permanent structural change. Either way, this is something that should be monitored closely in the coming months.

Core vs. Intermediate Government/Credit: Which to Choose?

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Our Chart of the Week examines the relative performance of Core and Intermediate Government/Credit fixed income strategies in rising and falling rate environments. The chart shows Core’s annual total return since the 1970s as represented in the blue using the Barclays U.S. Aggregate index. Annual total return of the Barclays Intermediate Government/Credit index is shown in orange. We also include inflation in green, using the CPI’s annual change, and the 10-year Treasury yield in gray. As one can see, Core beat Intermediate Government/Credit and inflation when rates dropped during the 30-year bull run for bonds from the 1980s to today. This is because Core features higher yields and longer duration, the latter of which boosts bond prices when rates drop. But Core lags Intermediate Government/Credit and inflation if rates rise significantly, as we experienced during the 1970s oil crisis. This was again because of Core’s longer duration. In other words, Core’s longer-dated bonds took much longer to be recycled out as rates rose and newer, higher-yielding bonds came to market; as a result, returns lagged.

Going forward, no one knows whether rates will go up or down. We performed projections based on the likely scenario that the Fed hikes 25bp per year for the next three years. We assume a flattening curve and the 10-year Treasury rises 10bp per year. In this scenario, we estimate that Core will beat Intermediate Government/Credit because of its higher yield despite its longer duration. If the economy gets worse, we assume there are no hikes and the 10-year Treasury yield goes to zero in three years. For this case, we estimate that Core will beat Intermediate Government/Credit handily because of both its duration and yield pickup. What it takes for Intermediate Government/Credit to beat Core is extremely strong economic growth or a dramatic inflationary environment where prices of goods skyrocket, during which we assume 0.5% or more of annual increases in the 10-year Treasury yield. Here, Core’s longer duration hurts it more than its higher yield. These estimates do not account for technical market selloffs or buying binges, but show what a perfectly rational market is expected to do.

As a practical takeaway, if investors are deciding between Core vs. Intermediate Government/Credit, this shows that Core is more resilient in the more likely scenarios. On the other hand, if an investor has chosen Intermediate Government/Credit for its lower duration, its performance will be relatively similar to that of Core in all scenarios. Ultimately, both strategies will provide liquidity, diversification, and safety in the event of market stress; relative performance across interest rate environments will not be significant, though core offers a bit higher upside under the most likely interest rate scenario over the next few years.

Is the U.S. on the Brink of a Recession?

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity.

The combination of rising high yield spreads and falling equity markets has led many investors to question if the U.S. is headed for a recession. This week’s chart examines the probability of a recession using the yield curve as a leading indicator of future economic activity. The Federal Reserve Bank of New York publishes a model that calculates the probability based on the difference (spread) between the 10-year and 3-month Treasury yields. As the spread narrows, the probability of a recession increases. Conversely, as the spread widens, the probability decreases. As the chart shows, this model has historically been a good predictor of future recessions. Based on January’s data there is only a 4.6% chance of a recession twelve months from now. Like all models, there are no guarantees that the predictive power will continue into the future, but this provides investors another tool to formulate future expectations.