Topic Tags: Interest Rates

The Re-Price is Right

Bank loans provide investors with many advantages, chief among them a floating rate feature that resets on a quarterly basis, benefiting the investor as interest rates rise. They also offer a senior secured top-of-an-issuer’s-capital-structure positioning, meaning that the bank loan investor has first-in-line access to the issuer’s assets should something go wrong. However, recent market dynamics have produced a phenomenon that cuts into bank loans’ attractiveness: re-pricings. A re-pricing is a renegotiation performed by the bank loan issuer with its bank loan investors. Typically occurring in rising rate periods, the re-pricing lets the bank loan issuer reduce the spread that makes up the total coupon it has to pay under its bank loan agreement. An example representative of several recent re-pricings is shown in this week’s chart.

The chart shows two time periods: one year ago (before re-pricing), on the left, and today (after re-pricing), on the right. One year ago, LIBOR, the base rate, was at 1.0%. The spread was 4.0%, making the total coupon, or yield, 5.0%. After the re-pricing on the right, as LIBOR increased from 1.0% to 1.5%–a direct result of the Federal Reserve’s recent rate hikes–the issuer has successfully renegotiated the spread from 4.0% to 3.5%. The total yield then remains at 5.0%. Bank loan issuers get to re-price only if the price of their bank loan exceeds par value, typically 101, and they can initiate re-pricings only after the non-call period ends, which typically lasts six to twelve months after issuance. High yield bonds, on the other hand, have much longer non-call periods, typically five years.

Currently, we are seeing large amounts of bank loan re-pricings. This is because of strong demand for bank loans, including re-priced bank loans, and a lack of supply in the form of new issuance due to low mergers and acquisitions activity, as the issuance of new bank loans is typically how an acquirer finances a take-over. Investors currently have an appetite for re-priced bank loans that is keeping the total yield after the re-pricing approximately equal to the total yield before the re-pricing. This phenomenon explains why bank loan spreads have remained close to their long term averages, as investors have not completely rushed into bank loans, which would have made spreads much tighter. We continue to recommend bank loans as a short-term and long-term allocation due to their moderate spread level, relatively strong yield (currently averaging 5.0%), and the aforementioned floating rate and senior secured features. As M&A activity picks up, we expect more new bank loan issuance, which would reduce the proportion of re-priced loans in the market, thereby raising overall yields on bank loan investment portfolios.

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Will the Yield Curve Invert?

The Chinese yield curve inverted recently. Does this mean that the U.S. yield curve might invert soon? What does inversion mean for investors? Inverted yield curves have been precursors of bad news for the equity market. In the past 20 years, the U.S. yield curve inverted twice, once in 2000 and once in 2006 and the S&P 500 subsequently dropped 48% and 53% following each inversion, respectively. When the yield curve inverts, it usually means that the market is pessimistic about the economy and drives up long bond prices as safe havens, thereby reducing their yields relative to short bond yields, which typically have been driven up by rate hikes.

This week’s chart observes several signals that appear just before the yield curve inverts. First, there are several years of a downward trend in the spread between 10-Year and 2-Year Treasury yields (also known as steepness) and an upward trend in the equity market, as the orange and red arrows show in the chart. Since the last inversion in 2006, we have seen this signal for a while. Second, GDP growth reaches its peak. For the last five years, GDP growth has been stable and at a moderate level, and it is unclear if it has reached a peak or could grow further. Lastly, it takes time for the spread to become negative and the change is not abrupt. Before the inversion, the spread was around 30bps in 2000 and 15bps in 2006. The spread as of May 2017 was around 50bps and still has room to contract.

Overall, there are several signals that suggest that yield curve inversion is coming. However, inversion is unlikely to happen in the near future. The current yield curve is reasonably steep, the market has a positive sentiment about the economy and other economic boosts from the Trump administration may come into play, such as job creation initiatives and tax cuts for businesses and consumers. Yield curve inversion is not yet impending.

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Fed Balance Sheet Normalization

The Federal Reserve recently increased its commentary on how and when to reduce its $4.5 trillion balance sheet, comprised of $2.5 trillion in Treasury bonds and $2 trillion in mortgage-backed securities (MBS). Shown in this week’s chart, that amount grew at a rapid rate from under $1 trillion during the 2008 financial crisis to where it is today. This growth was the result of unprecedented monetary stimulus in the form of large-scale bond-buying to keep the economy afloat by flooding it with cash through the Great Recession.

Recent commentary suggests that the Fed might gradually normalize its balance sheet later this year at an expected rate of $1.5 trillion spread over five years. The minutes released this Wednesday from the latest Federal Open Market Committee meeting show even more clarity on this process: The Fed intends to pre-announce, on a regular basis, caps on the amounts of bonds that it would allow to mature without reinvesting. It would start at very low caps and would then raise these caps on a quarterly basis, depending on how strongly the economy continues to grow. The minutes stated, “Nearly all policymakers expressed a favorable view of this general approach.”

Gradually reducing the Fed’s balance sheet may have a similar effect as hiking rates, which the Fed is expected to continue to do. It may ultimately increase Treasury and MBS yields and put downward pressure on their prices as the Fed reduces its role as a buyer. The market is expected to counter this effect, however, as international demand for Treasury bonds remain strong given the continued low and negative rates in countries such as Germany and Japan. Moreover, the market was able to absorb about $5 trillion of MBS during the housing boom, and is expected to absorb much of the MBS that is not retained in by the Fed. The ultimate effect on interest rates from these two opposing forces is unknown, but at the least they should mostly offset to prevent a rapid increase in interest rates.

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Rate Hike: Yellen Pumps the Brakes a Third Time

March 2017

The Federal Reserve voted on March 15, 2017 to hike the fed funds rate by 0.25%, targeting a range of 0.75–1.00%. The vote was nearly unanimous — nine versus one out of the ten total voters on the Federal Open Market Committee — with Minneapolis Fed President Neel Kashkari voting for no change. This is the third hike after the Great Recession, following the 0.25% hikes in December 2015 and December 2016.

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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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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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Will Cyclical Outperformance Continue for U.S. Equities?

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

This week’s chart highlights recent changes in sector leadership across U.S. equities.

The first half of the year was marked by global growth concerns coupled with reduced expectations for further interest rate hikes in 2016. As this sentiment became priced into the market, a flight to perceived safety ensued which helped to fuel the strong performance of defensive sectors. Telecom, Utilities, Real Estate, and Consumer Staples were the main beneficiaries of this trend. Additionally, these sectors tend to offer attractive dividend yields. Strong interest from yield seeking investors, given the current low interest rate environment, helped propel performance and valuations to elevated levels within these sectors.

The third quarter saw signs of improved economic growth in the U.S. along with positive earnings growth for the S&P 500. The third quarter earnings growth followed five consecutive quarters of negative year-over-year growth. Cyclical sectors were the main beneficiary of these growth improvements, and this trend has continued post-election given the pro-growth rhetoric of a Trump administration and the subsequent expectation of higher interest rates in the future.

This performance leadership from cyclical sectors may continue — at least in the near-term — given the headwinds facing defensive sectors (valuations trading at premiums to the broad market and expectations for higher interest rates) as well as the tailwinds for cyclical sectors (valuation levels relative to defensive sectors and higher expected GDP growth).

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.