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Two Sides of a Coin
By Benjamin Streed
February 06, 2012

The beginning of last week appeared to be yet another one dictated by a “risk off” mentality, and thus, lower yields on U.S. Treasuries. In fact, going into Friday Treasury yields were down considerably with longer-dated maturities showing the bulk of gains; the 5-year was off 4bp (0.70%) hitting record low yields nearly every day, the 10-year was off 7bp (1.82%) and the 30-year bond was off 5bp (3.00%). A combination of worries weighed on the markets ranging from the underwhelming U.S economic data and the Fed’s recent testimony, to ongoing concerns in the Euro zone over a potential solution to the ongoing Greek debt drama. Friday, the world was turned on its head after strong job-creation data in the U.S. surprised global markets and fueled a reverse from “risk off” to “risk on”. As previously noted, yields were down going into the 8:30am release on Friday, but soon afterward everything changed. The pronounced selloff in Treasuries on Friday pulled yields across the curve into positive territory for the week; the 5-year finished up 2bp (0.76%), the 10-year was up 3bp (1.922%) and the 30-year gained 6bp (3.11%). The chart below details the change in basis points for each benchmark Treasury going through the week. Changes in yield were all negative through Thursday, but notice the spike Friday morning that sent yields up for the week. Corporate bond yields are taking their cue from the Treasury markets as yields approach lows not seen since late 2010. According to the Citigroup Broad Investment Grade index (Citi BIG), corporate yields hit 3.31% last week, its lowest level in over two years. Going into this week, eyes will remain on the Euro zone and its ability to provide a solution to the ongoing debt crisis. The markets continue to walk on a thin wire and it remains to be seen whether the markets will continue with a “risk on” mentality with higher yields, or whether it will pull yields back down and revert to “risk off”.

Corporate Bonds Stage a Comeback

According to Bloomberg data, corporate issuers continue to take advantage of near record-low interest rates as they issued nearly $70 billion in new debt last week. Despite last week’s strong showing, January’s total issuance of $336 billion was the slowest start to a year since 2008. Corporate issuance is staging a comeback after Fed Chairman Ben Bernanke pledged to keep interest rates low through at least 2014 and it appears that we may see some sort of resolution to the ongoing Greek debt crisis. The Fed’s pledge led to a general rally in the “belly” of the yield curve, with 5 and 10-year maturities seeing the bulk of gains. International Business Machines (IBM), McDonald’s and Procter & Gamble (P&G) helped spur a 75% increase in issuance last week with each obtaining record-low interest rates for various maturities. P&G issued $1 billion of 10-year notes, paying a record-low coupon of 2.30% for that maturity while IBM was able to sell $1.5 billion of notes due in 3-years at a record low 0.55%. McDonald’s chose to move further out on the yield curve, issuing $500 million of new 30-year bonds at an all-time low of 3.70%. With intermediate-term rates being the focus of the Fed’s actions, it would seem likely that corporate issuers would focus their attention on this portion of the yield curve. Interestingly, the general “risk on” trade in the markets over the last month pushed longer-term rates down as well, helping to entice many corporate borrowers into the market. Issuance of corporate bonds that mature in more than 15 years was up 64% in January. This compares to a monthly average of only $8.3 billion for all of 2011.

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To Infinity and Beyond ...
By Zach Berg, CFA
January 30, 2012

... or at least to the end of 2014. The Federal Reserve provided further policy easing this past week, this time through its communication strategy by increasing the time it conditionally expects to keep rates low, while also potentially signaling that QE3 may be warranted in the future. In its FOMC statement release, the Fed altered the language concerning the target range for the Fed funds rate, pushing out its expectations for a rate hike 18 months by replacing a mid-2013 commitment with the following, “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Additionally, the Fed openly adopted an explicit inflation target of 2% on the headline Personal Consumption Expenditure (PCE) inflation index within the context of its dual mandate to maintain price stability and promote maximum employment. The markets reacted swiftly with Treasury prices moving higher (yields lower) across the curve, while in other fixed income markets investors faced with lower rates for longer looked to pick up incremental yields in other fixed income product types. Within the broad Treasury move, the belly of the curve experienced the greatest relative compression with the 5yr note hitting a record low yield at the time of 0.76%. That level would be later taken out throughout the remainder of the week, as the belly of the curve re-priced the Fed remaining on hold for even longer.

Interestingly, although the FOMC statement contained the language implying an initial rate hike may not occur until late 2014, the fed fund futures market does not currently reflect this timing cycle. As the chart below displays, the market clearly pushed out expectations, but only to mid-2014 as opposed to the end 2014. It appears that traders are formulating their rate hike expectations around the distribution of Fed participant’s forecasts versus the actual statement language.

This discrepancy may create a situation in which 5yr yields have the potential to set even lower record yields over the next few weeks if the fed fund futures market begins to move closer to the statement language. While this type of move would flatten the front-end of the curve for a majority of fixed income products, it would also have the potential to create a steepening bias in the 5-10yr portion of the yield curve. A flat front-end and steeper intermediate Treasury curve equates to greater roll returns, as well as, increasing the need for alternative sources of carry for institutional investors which may increase the attractiveness of higher yielding fixed income assets such as corporate bonds and mortgages.

On the long-end, 30yr yields initially reacted Wednesday by falling approximately 18bp, but later retreated from those levels during the day, partially on the prospects of further quantitative easing, which is associated with higher inflation expectations. Although the Fed stated their inflation objective of 2%, Chairman Bernanke relaxed this target as a hard line in the sand during his press conference, implying a Fed’s willingness to temporarily tolerate a higher inflation level if it were viewed as a means to stimulate a stagnant economy. This admission to allow a short-term observance of higher inflation at the cost of avoiding deflation and sparking economic activity, coupled with the simple fact that the Fed appears to be on hold for a more extended period has historically led to higher inflation expectations. Additionally, the prospects of further quantitative easing, which Chairman Bernanke stated in his press conference was under consideration, may also add to these pressures. However, unlike the announcement of QE2 which pressured long-dated rates as the inflation expectations component increased, the announcement of an explicit long-term inflation target of a 2% may have the ability to stem a rampant increase in inflation expectations helping to reduce the stress on long-dated yields. The confluence of these dynamics will be worth noting during upcoming weeks as the Treasury yield curve, especially the 2-5yr, 5-10yr and 10-30yr curves reposition themselves.

With the first release of the Fed’s projected rate path out of the way, the Greek debt drama may move back to the forefront this week. European Economic and Monetary Affairs Commissioner Olli Rehn was quoted Friday by Reuters saying, “We are very close to a deal, if not today then over the weekend and preferably in January.” The need to move quickly on a deal is growing with each passing day as the March 20^th payment of €14.4 billion gets closer and closer. The possible outcomes to the private sector involvement (PSI) debt negotiations that are currently taking place are complicated, but here are four broad simplified issues to be mindful of:

• Will any accord reached be able to invoke at least a 90% voluntary private sector debt holder response? A failure to reach this level of participation will create a shortfall that will need to be filled by either the International Monetary Fund (IMF) or the by EU, in the form of the ECB. It would be unlikely that the IMF would step into this role based on the need for a parliamentary vote; however, the ECB would require no such vote making it a more likely candidate.
• If the Greek PSI deal falls apart and no deal can be reached, a negotiation between Greece and the “Troika” (the European Commission (EC), IMF, and the ECB) will need to occur to secure a bailout needed to avoid a missed payment and a default. These discussions would likely center on greater austerity measures in the form of fiscal and structural reforms.
• The end game of no agreement between the “Troika” and Greece may very well be a Greek exit from the EU. A further implementation of harsh austerity measures may be too great a burden for the Greeks to bear considering that according to a report on Friday, Greece is already developing a plan to leave the EU. (Greece plans orderly exit of the Eurozone – International Trade Examiner)
• In any of the latter three scenarios above, a key question will be whether or not a credit default swap event is triggered. Certainly in the last and worst possible outcome a CDS event would surely be triggered, but the answer to the middle two would be based on the structuring and losses debt holders may have to take.

Adding to the complication of the Greek negotiations are news headlines stating that Germany wishes to have the EU run the Greek budget. Not surprisingly Greece has rejected these calls, potentially setting the stage for breaking news barrage this upcoming week of back forth between Greece, Germany, and the rest of the “Troika.” Thus the week ahead commences with a market anxious for a Greek solution and once again susceptible to volatile trading swings as Treasury yields begin the week lower across the curve.

A Little Food for Thought ...

This past Thursday, the Japanese Finance Minister made the announcement that it is projected that at the end of their fiscal year in March 2013, the amount of total Japanese debt will surpass the one quadrillion yen market. Yes, one quadrillion yen or roughly $14 trillion U.S. dollars. In a Bloomberg article entitled “The Long Malaise: Similarities Between Japan and the U.S.,” author Joseph Brusuelas compares the Japanese lost decade to the current US economic backdrop. While he acknowledges the differences between the economies, especially the large variation in the consumer behavior of each country, the similarities are strikingly similar in some aspects. He states, “These similarities primarily relate to the unique problems following the piercing of a debt-financed asset bubble that left many households, banks and firms with liabilities that exceeded assets following the bursting of a residential asset bubble.” The U.S. just recently passed the 100% debt-to-GDP ratio, which as Brusuelas points out took just four years for the U.S. to accomplish from the onset of the recession, while it took Japan six years to do the same. For investors asking themselves how long can yields remain depressed, there is a non-trivial similarity between the paths of US 10yr Treasury yields are their comparable Japanese 10yr yields through the first four years following the recession. In the case of Japan, yields continued to fall before finally coalescing in a tight trading range of 0.50% to 1.00% where they remain today.

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A Not So Happy New Year
By Benjamin Streed
January 23, 2012

The first couple of weeks in any new trading year can be interesting for the bond markets as issuers gauge investor appetite for yield. According to Bloomberg data, January is shaping up to be a little anemic when it comes to new corporate bond issuance, with only $78 billion issued over the last 12 trading days. If we ignore 2009’s comparable $74 billion in issuance over the same period, 2012 is the lightest January in volume since the credit crisis. Much of the lackluster issuance can be attributed to ongoing worries from the Euro zone and its never-ending sovereign debt drama. In the face of this unease, Treasuries have continued their year-end rally, although constrained to the shorter-term maturities as investors seek the safe-haven status of U.S. Treasury securities. According to YieldBook data, benchmark Treasuries have returned a positive 2bp, 13bp and 19bp for 1-,3-, and 5-year maturities respectively. On the surface these roughly breakeven returns may not seem noteworthy, but for most of these maturities these are the weakest mid-January returns for shorter-term Treasuries since 2009. Longer-dated Treasuries have fared poorly so far, with the 10-year note and 30-year bonds returning -4bp and -75bp apiece. Corporate credit tells a vastly different story as we move into February, with both higher and lower-rated credit performing well in the first few weeks of trading: AA-rated +55bp, A-rated and BBB-rated debt have returned 79bp and 163bp respectively. While not record-breaking, these returns are considerably better than their comparable 2011 returns.

Moody’s Issues a Warning for Global Banks in 2012

Last week, Moody’s published an updated report on why they perceive the upcoming year to be a challenging one for many global banking institutions. They see several adverse trends creating headwinds for the industry including: deteriorating sovereign creditworthiness, particularly in the Euro zone; elevated economic uncertainties; and increasing funding costs and reduced access to funds during a time when many banks face upcoming debt rollovers. The ratings agency believes that these challenges will primarily affect European banks as well as those global institutions that engage in capital markets activities around the globe. On the bright side, Moody’s expects banks that operate in a more robust environment (global and regional diversification) and are more focused on retail operations will have an easier time navigating the potentially difficult environment. In conclusion, the report notes that many banks are expected to face a downgrade in their “standalone credit rating” and anticipate placing several banks under review for potential downgrade in the first quarter of the year. Interestingly, Moody’s also notes that, “Our broadly downward outlook on bank credit profiles reflects the acceleration since second-half 2011 of interrelated trends that we expect will persist, even after the current acute market turmoil dissipates.”

Taxable Bonds: Still Feeling the Love

According to the Investment Company Institute (ICI) a national association of U.S. investment companies, including mutual funds, closed-end funds, and exchange-traded funds, the inflow of long-term investment funds toward bonds continues to be strong. Following the trend that began after the start of the recent financial crisis, fund flows towards bond funds continue to show strength. This trend is most noticeable in taxable fixed income which has routinely provided the majority of fund flows for all fixed income products: year-to-date 70% of net fund flows have been to taxable fixed income, while an average of over 130% (due to negative flows in other fixed income products) has occurred since this time last year.

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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.

To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.

Laurence E Menna, CFP® Financial Advisor Contact Us