Bond Market Commentary
Bond Market Commentary
US credit: Feeling the effect of European QE
By Benjamin Streed, CFA
July 25, 2016
In my last note I detailed how the US Treasury market holds an enviable position in today’s global marketplace, a respectable yield paired with a large/liquid marketplace. Taking this idea one step further, how are spread products like US corporate debt looking compared to other areas of the world? As we’ve long suspected, ongoing monetary stimulus in the form of quantitative easing (QE) in both Europe and Japan, in which central banks are directly purchasing bonds in the marketplace, have pushed many yields well into negative territory. With an estimated ~$13 trillion in high quality, sovereign debt now yielding less than zero there is a clear message being sent to the markets: seek safe yield wherever you can. The European Central Bank (ECB) increased its commitment to monetary stimulus in March, with ECB president Mario Draghi stating he would do “whatever it takes” to stoke growth and inflation. As you’d expect, yield spreads across the globe immediately fell as the chase for yield was once again in full force. The chart below details two Bloomberg Composite indices, domestic (white) and European (red) with spreads on top and index yields in the lower pane. With nominal European corporate yields now sitting at only 51 basis points (bp), the US average of 282bp, a pickup of ~230bp for a similar credit rating and maturity, looks incredibly attractive in a world where investment opportunities are less likely to be weighed in isolation, and instead are more likely to be considered on a global scale.
Although the spreads above are only ~60bp different, those readers that caught my piece two weeks ago will recall that US Treasuries out yield European sovereign debt by a considerable margin, thereby making any US debt product that much more attractive. As a result of this global shift and renewed focus on yield, investment grade (IG) corporate credit in the US is once again performing well, with BBB-rated issuers outperforming higher quality (less spread) A and AA-rated debt. More information on yields, spreads and returns on various domestic credit indices can be found in our Weekly Index Monitor. Year-to-date, the Citi IG Index is up 8.92%, not bad for an approximate 10-year average maturity, an effective duration of ~7 and an A- credit rating. The table below details each sub-index, broken down by credit rating and industry for those looking to focus on finance, industrial and utility issuers. For several years our strategy team has highlighted the potential benefits of owning BBB-rated issuers and the outperformance potential of those issuers with higher than average spread. As expected, the global hunt for yield is having an effect on domestic credit, and for those seeking some mixture of safety, liquidity and yield, the US still appears to be the only game in town. Is it any wonder why investors overseas are looking beyond US Treasuries and finding value in nearly every corner of our markets?
Bonds – plodding along
By Doug Drabik
July 18, 2016
We are in very different times for nearly any investor who is alive today given that interest rates are at all-time lows and haven’t been close to these levels since the 1940’s. For the first time, interest rates are at zero or negative in several European countries and Japan. Technology is changing the balance of energy dependence/independence, age demographics are affecting saving, health care costs, and consumer spending, debt levels are excessive, the Euro zone framework is shifting and there is considerable central bank intervention. Comparisons to similar historic moments simply do not exist.
For years now, it is easy to find articles and advise proclaiming “now is not the time to buy bonds”, when all along one of the best possible moves was to buy bonds and buy duration. Why? Well it is very tempting to say because bonds have been a great total return play and provided portfolio growth outshining nearly every asset class. The faulty logic that proclaims bonds inadequate as prices fall (yields rise) is then applied to declare new “don’t buy” warnings because rates are too low. Well which is it?
Neither! We are in the midst of over 34.5 years of general interest rate decline. We have highlighted in the Fixed Income Quarterly how experts and investors alike fail miserably to predict future interest rates. The easy task at hand is how to handle the fixed income portion of your portfolio. Again, although it would be easy to declare the superior total returns bonds have experienced over many asset classes over the last several years, the truth is that’s been a side benefit. Bonds are mostly purchased to be the counter to other asset classes such as stocks, not a substitute for them. They provide wealth protection through certainty of cash flow, income and maturity. The reverse is also true. Stocks or other asset classes cannot substitute for these bond characteristics.
Although we are in a unique historic economic and political time, the constant in asset allocation is the dollars dedicated to wealth preservation and income: higher quality individual bonds! The world events, predictive expectations and media noise are distractions that persuade irrational investor behavior. Avoid untimely maneuvers with misplaced substitutes by knowing what you own and why you own it. Despite their recent success, bonds are not typically growth asset substitutes just the same as those asset classes are not good substitutes for bonds’ cash flow, income and maturity.
The only game in town
By Benjamin Streed, CFA
July 11, 2016
To put it simply, financial markets are in a strange and somewhat unexpected place. Equity markets in the US have recovered to pre-Brexit highs with the S&P 500 flirting with its record 2130 (closing level) set back in May. However, the global bond markets appear to be singing a very different tune as increasing amounts of global sovereign debt is pushed into negative yields thanks in part to monetary policy in Europe and Japan. As we’ve noted in previous writings, domestic monetary policy is unclear/uncertain (at best) but the one thing that is becoming strikingly obvious is the undeniable influence overseas central banks are having on the US bond markets. For example, recent estimates have negative-yielding sovereign debt in the vicinity of $10 trillion leaving many “safe haven” investors in dire need of not just safety and liquidity but a positive yield. If you’re an overseas investor, it’s almost a no-brainer that you’d seek out these high yielding instruments that also just happen to be the world’s largest and most liquid “risk free” asset. According to Citigroup, US Treasuries now account for nearly 60% of all positive-yielding sovereign debt and also represent ~90% of all positive yields with a short maturity of less than one year. If you want/need to stay short-term and risk-free, there is apparently only one place on the entire planet to go, here. Think about the potential ramifications of that last statement; how much will US monetary policy (the Fed) really influence the short-end of the yield curve if T-bills are the only game in town for short-term, high-quality debt? There are some indications that this demand is already having a meaningful impact on some of deepest parts of the Treasury market.
According to US Treasury data, demand for US Treasuries is so high that “stripping” bonds, i.e. separating a bond into its component principal and interest payments now stands at a record $223 billion, the highest level in more than seventeen years. Most of the stripping is focused on maturities in 2045 and 2046, utilizing the most long-term of all US securities available in the market. In many ways, who can blame them? Year-to-date, the benchmark 30-year bond has returned a staggering 22% and is up nearly 26% over the last twelve months. For those investors willing to maintain longer-term bonds in their portfolios, duration truly has been their friend. As a result of the ongoing “duration demand”, the Treasury curve has flattened to its lowest levels since 2007 (see the chart above). The difference in yield between the 2yr and 10yr Treasury notes sits at only 75 basis points (bp) while the 2yr to 30yr difference is a mere 147bp.
Meanwhile, with the recent equity rally the markets are at a clear inflection point with equities at/near record highs and yields at/near record lows. Equities at all-time highs would indicate that Brexit-related concerns have subsided and that the “all clear” has been signaled. However, bond yields at record lows offer up a conflicting view of the world, or at least one that is much less convinced that the “all clear” has been signaled at this juncture. Luckily, the markets will get some additional clarity from the regional Fed banks this week in the “beige book” survey. Markets will pay close attention to the details of this report for any indication that domestic monetary policy could be back in action before the end of the year. Alongside this report, inflation figures (PPI and CPI) as well as retail sales and industrial production will arrive in what is set to be a busy week.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.