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Bond Market Commentary by Mike PetersenOne Year Ago
By Mike Petersen
March 8, 2010
We look back this week and reflect on the one year mark from the March 9th equity index lows during the credit crisis. After staring down what may arguably become the largest test of the free market credit system in history, it seems appropriate to gain some perspective. The Dow Jones Industrial Index has gained nearly 62%, the S&P 500 has gained nearly 68%, and the cost to insure corporate bonds against default has declined nearly 67% (according to Markit IG CDX Index), all illustrated in the chart below. Yields on single A rated 5 year maturity bank credits have declined 35%, single A rated industrial yields have declined nearly 30%, according to Bloomberg Fair Value Curves. In general, yield curves on nearly all fixed income assets have steepened significantly since that time, signifying increased confidence in the potential for an economic recovery. The Federal Reserve has now begun repealing some of their actions after taking extraordinary measures to halt the crisis. With that brief perspective, we look ahead to what the rest of 2010 may hold.
Year of the Coupon
Within the corporate bond space we are revisiting the theme of coupon cash flows becoming a large component of investors’ potential near term returns, especially as the risk premium (spread) relative to yields on government debt slows in its contraction. Investors continue to plow money into fixed income funds, EPFR Global cited 61 consecutive weeks of inflows for U.S. bond funds. This may be a critical time for investors to look at individual bonds as a component of a diversified portfolio. Movements in credit spreads and underlying benchmark rates are two components which may affect principal values. If the bulk of spread contraction has already happened within our look-back period and if the FOMC holds movements in benchmark rates until 2011, principal values going forward may not appreciate as much as they have over the past twelve months. Thus, we emphasize the returns gained through coupon payments. Fundamental yields for various sectors within the single “A” rated space are illustrated below to give a current view of the corporate bond yield curve.
The Greek Effect Fades
Greece successfully issued 5 billion in new Euro denominated debt this week and released a plan to dramatically cut budgets by 4.8 billion Euros to help regain fiscal control. Many in Europe and around the globe saw these steps as positive. Thus the lingering effects on the markets due to this uncertainty began to fade. The cost of protection against default for corporate bonds fell to a six week low of 85.35 according to Markit IG CDX Index as you can see in the chart below. As market fears calmed globally, debt markets appeared to fall into a lull. TRACE, the NASD Trade Reporting and Compliance Engine, recorded trade volumes down nearly 9% week over week according to MarketAxess.
Old Man Winter’s Unemployment
After taking his proverbial shot of Ouzo last week, Old Man Winter forgot to exert his effect on unemployment. Friday’s unemployment numbers were largely anticipated to hold a larger increase due to late season storms pushing through most of the North East. As the numbers were released Friday, the report showed unemployment actually remained constant at 9.7%. Many analysts predicted unemployment to raise a tenth of a percent to 9.8%. Since unemployment was less than expected, treasuries sold off driving yields higher. With that news Treasury rates pushed to the high point of the week, with the yield on the ten year note maturing 2/15/20 reaching 3.69%. (see chart below for YTD yield graph). Ahead this week, the government is due to auction new 3, 10, and 30 year notes. With a light economic calendar, auction results could be a market mover.
Looking Ahead...
Range bound trading may continue. The economic calendar is light, with things not expected to heat up until late in the week with Jobless Claims Thursday, then Retail Sales and Consumer Sentiment Friday. Auctions for this week are: Tuesday $40 billion in 3-year Notes, Wednesday $21 billion in 10-year notes, and Thursday $13 billion in 30-year Notes. Corporate issuance may also continue to pick up after a relatively quiet period at the start of February. We’ve seen $34 billion in issuance the last two weeks, compared to $6.8B the preceding period, according to data compiled by Bloomberg.
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.
Old Man Winter Takes Shots of Ouzo
By Zach Berg
March 1, 2010
Old man winter was back this past week slamming the northeast, with what some have called “Snowicane,” while the markets were left contemplating the effects of a different kind of storm. Sovereign default risk was back in vogue, along with Bernanke speak and some lower than expected economic data. Leading into the week, many focused their attention to Fed Chairman Bernanke’s semi-annual Humphrey-Hawkins address to Congress. Throughout the testimony, Bernanke reiterated previous Fed speak stating, “The FOMC continues to anticipate that economic conditions – including low rates of resource utilization, subdued inflation trends, and stable inflation expectations are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” He quelled any anxiety relating to the unexpected raising of the discount rate and maintained that job growth would be essential to a long-term recovery. With Bernanke providing little new insight on potential Fed moves, the markets turned their attention to southern Europe.
Put Some Windex On It
By far, the dominating market force from last week centered on the continuing saga involving Greece and the European Union (EU). As now widely known, Greece has a bit of a budget problem in the realm of a budget gap totaling 12.7% of their GDP, well above the 3% EU limit. In response to EU pressure, Greece has proposed a €2 – €2.5 billion package that includes substantial spending cuts and tax increases to close the gap. However, these proposed cuts would have a pronounced effect on the civil work force of Greece and has led to violent protests and riots in the country. To add to the fire, the EU is urging Greece to enact further cuts in the area of €4 billion. The situation has led to increased tensions within the EU as S&P and Moody’s have threatened further downgrades of Greece’s debt if the country is unable to get its house in order. While Greece represents a very small portion of the total EU GDP (only 2%) the larger issue would be a systemic event that a Greek default may have if it were to travel to a nation such as Portugal or even Spain, the fourth largest economy in the EU. Gluskin Sheff noted this past week in their daily commentary that, “According to Commerzbank, 60% of new Greek bond issuance in recent years was gobbled up by non-Greece European borrowers.” Also, consider these figures from Morgan Stanley contained within their note
- 51% of Portugal’s debt is owned by Spanish banks
- 32% of Spain’s debt is owned by German banks, 25% is owned by French banks
From these numbers it becomes apparent the potential widespread effect that the default of one member of the EU could have on the entire bloc. Of interest in the coming weeks will be how the talks between the EU and Greece progress, and if or how will any financial assistance be organized by the union.
With the fears of a potential European Union debt crisis raging, domestic economic data added to the pressure with less than stellar numbers. A significant drop in consumer confidence, new and existing home sales, and an increase in continuing unemployment claims figures renewed concerns regarding the US recovery. Overall, the treasury curve flattened as 10-year and 30-year note yields rallied roughly 17 basis points in yield during the week. The chart below using Bloomberg data, shows the yield on 10-year notes during the past 5 months with the channel (the white box) depicting the yield range during 2010. During last week, the 10-year was able to break through several technical resistance levels. It now finds itself 5 bps from touching the low, 3.562% set back on 2/8 when the Greece deficit concerns initially surfaced. If there’s enough left in the tank, a break below this 3.56% level would be a very significant move. For those worried about rates moving higher, the graph illustrates the 10-years recent upper support levels in the 3.83-3.84% area.
In Focus – Corporate Earnings
In the credit arena, unlike three weeks ago when spreads widened considerably on the fear surrounding the Greek crisis, corporate bonds were able to sustain their bid. On both a nominal and credit default basis, corporate spreads finished the week at roughly the same levels that they began. In large part due to earnings releases, corporates have enjoyed a considerable spread tightening from the February 8th blowout. In a positive sign for corporation profitability, fourth quarter earnings have been strong from a bottom and top line view. The charts below depict Bloomberg data for S&P 500 companies’ earnings for both the bottom line, net income figures, and top line sales data. The timeline on the chart spans previous quarterly announcements as well as uses Bloomberg estimates to predict future results.
S&P 500 Previous and Potential QuarterlyNet Income Growth
S&P 500 Previous and Potential QuarterlySales Growth
The graphs clearly illustrate the return to profits for many firms from the cratering effects of the recession. On the net income side, this quarter has had robust income figures from material, industrial, and consumer discretionary firms. However, as the chart looks forward, the net income figures become flat lined as firms continue to remain profitable, but face steady yet unimproving growth with a potential sideways economy. From the top-line figures, it is encouraging to see real growth in sales numbers led firm’s profitability instead of the cost cutting measures seen in previous quarters. As the graphs displays, the prospects for further growth in the upcoming quarters look promising. However, when examining the projections for growth on a sector basis, financials are widely skewing this figure higher as they are able to take advantage of the upward sloping yield curve. When removing their effects, the rest of the S&P 500 companies appear to have even growth, similar to the chart for net income as they face tempered consumer demand. Using the S&P 500’s earnings as a proxy, the continuing strength and positive growth implied by the charts in both net income and sales should lead to even tighter spreads in the corporate bond markets. It is important to note, these figures are simply projections and can be subject to sizeable adjustments.
What’s on Tap?
As the northeast shovels itself out of the snow, the markets attention will again focus on the developments in Europe and the vital employment numbers due out Friday. Due to the first “Snowicane” in early February coinciding with the survey week for the payrolls figures, many economists are predicting a negative print on the data. The consensus will be for an easier dismissal of a poor number, but a surprise gain will likely put significant pressure on treasury yields. In addition to the jobs data, the markets will digest new economic information on inflation (PCE deflator), manufacturing, consumer confidence, pending home sales, and the information contained within the Fed’s Beige book.
A little food for thought...
This week’s thought focuses on the flow of money and the shadow banking system. The shadow banking system is the name given to the lending activities that occur between the non-traditional bank institutions such as insurance companies, investment banks, corporations and pension funds. The complete meltdown and credit squeeze that occurred in these markets was the foremost factor in the credit crisis. For example, when the commercial paper markets, which are part of the shadow banking system, became frozen, firms such as GE and CIT Group were left scrambling to replace their access to short-term funds. With many focused on the access for credit for smaller institutions and individuals, a new study has been conducted on the current state of the financial system. The study was conducted by a collaboration of economists from Goldman Sachs and Deutsche Bank and academics such as former Fed governor Fredrick Mishkin. While conditions improved during the first half of 2009, thanks to the Fed’s unprecidented liquidity measures, the results showed that financial conditions tightened during the second half of 2009. One of the main laggards in the system was the securitization of asset-backed loans. These securities consisting of commercial real estate, car, and other bank loans amounted to $700 billion in new issuance during 2006, according to SIFMA data. While last year, only $168 billion were issued. In a Wall Street Journal article, Jan Hatzius, chief economist at Goldman Sachs, remarks about the study saying “The fact that financial conditions are still impaired, at least in some parts of the system, is consistent with the idea that the recovery is going to be a slow one. It also suggests inflation and bubbles shouldn’t be a big worry in the U.S.” While it is widely known of the struggles in the securitization markets, the study reminds us of the damaged caused by the credit crisis on the short-term funding available to firms. Consider as many start to question when the Fed will begin to drain liquidity from the system, that without a properly functioning shadow banking system, firms funding needs may become further strained if the Fed moves to quickly.
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.
Fed Speaks Yields React
By Mike Petersen
February 22, 2010
Federal Reserve comments were a key focus this week as the Fed unexpectedly raised the discount rate for the first time in three years 25 basis points to 0.75%. The discount rate is the direct rate charged to financial/depository institutions. Participants in the market took this as a strong signal that the Fed is beginning its work to unwind the many extraordinary measures put in place during the credit crisis. Atlanta Fed President Lockhart and Fed Governor Duke both commented in speeches this week that the move in discount rate did not signal a tightening of policy. In addition, New York Fed President Dudley commented after a speech this week that “We got an inflation report that showed there’s no inflation pressure,” and “so our focus needs to be on growth and jobs.” Most telling may have been St. Louis Fed President Bullard’s comment that “the central bank may not lift its benchmark rate until 2011.” So as Chairman Bernanke is scheduled to present his semiannual Humphrey Hawkins testimony this week to Congress, the fed speak may continue to influence the markets. Any comments on further measures to reduce the Fed balance sheet and return it to holding strictly treasuries should bear influence on the markets.
Treasuries reacted to the news by pushing the yield on the 10 year Treasury to a five week high of 3.80% on 2/18/2010. (The prices of Treasury securities decline as yields increase). The yield curve reached a record steep measure right before the Fed announcement. A steep curve is typically indicative of economic growth and investors demanding more yield as maturities extend under the anticipation the Fed may begin raising the benchmark rate. The inflection of the curve as measure by the difference in the 2yr to 10yr rates touched 294 basis points or roughly 2.94%. Both the 2yr and 10yr notes reached yield levels not seen since mid-January. The U.S. Treasury is set for another record tying issuance this week including the first 30 year TIPs issue since 2001. Participation levels from indirect bidders should be a key metric to watch. Recent weakness has caused concern in the market that foreign buyers may be stepping away from U.S. sovereign debt.
Continued uncertainty and the migration away from elevated risk assets lead the credit markets to extend the trend of lower weekly volume measures to 4 weeks. Spreads finally stabilized this week as the migration out of risky credits seemed to take a pause. According to Market Axess weekly trade volumes were down 5%. Many investors are looking to the intermediate maturities for protection from long-end volatility and the additional yield pickup from depressed short term rates. Keep in mind that spreads on credit have significantly tightened over the last year. The Bank of America Merrill Lynch Global Broad Corporate Market index has dropped from 452 basis points a year ago to 169 this past week. With slowing spread movement, investors are now more focused on comparative value and the perceived risks with a gradually improving economy. Reduced weightings in volatile or fringe credits may signify that investors are looking for quality and safety until a clear economic bias emerges.
As the economic calendar heats up this week and the Fed speak continues, market reaction will tell the story. Will the 10 year note push the upper limits of its recent trading range or will we see a rally which leads to lower yields? The stock market has appeared to contain itself in a range as well for the last 5 months so it remains a challenge forecasting which bias should prevail. "Range Trading" could ultimately prove to be the story for 2010 as we remain in the early stages of economic growth with many uncertain hurdles yet to overcome.
Chart of the Week
Markit CDX investment grade index pulled back for the second week in a row, signifying market participants are calming over concerns on corporate credits. The index measures the cost of insuring the debt of 125 entities against default.
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.
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