James Camp, CFA, Managing Director of Fixed Income, Eagle Asset Management* explores the effect of low inflation and low interest rates on credit markets and specific fixed income sectors.
Former Federal Reserve Chairman Alan Greenspan made headlines recently with his ‘bond bubble’ commentary. Interest rates, he explained, are as low as any point in history; thus, rates have only one way to go. Yet, persistently low inflation and continued expansion of global central bank balance sheets suggest a sharp rise in government bond yields is not imminent.
Flow of central bank money and low inflation are the key drivers of sovereign yields. The nearly $19 trillion of new money created by global central banks produces too much liquidity inertia for bond bears to overcome.
Though we suspect global rates bottomed last summer, their rapid increase after the U.S. election proved short-lived.
Central bank activities are fungible. Though the Federal Reserve (Fed) is suggesting a plan to unwind quantitative easing, other central bank balance sheets continue to expand. Global monetary policy is co-dependent in nature. Rates follow year-over-year changes in aggregate central bank bond buying, not just Fed activities.
Importantly, the ‘unwind’ in the U.S. is expected to be gradual and inconsequential from a rate standpoint. Assuming the plan is not interrupted by political or economic events (unlikely, in our view), it will take a couple of years to have any effect on rates. Even then, according to the Federal Reserve Bank of Kansas City’s research, a reduction of $675 billion in balance sheet assets is equivalent to a 25 basis point hike in the federal funds rate.
The real risk to the bond market, and capital markets in general, is the buying stampede in credit. The Fed has increased short-term rates four times since late 2015. Yet, financial conditions, a broad measure of credit availability, are as loose as any time since the Great Recession. This explains, in large part, the continued strength of risk assets across the capital markets.
Marginal borrowers continue to tap the debt markets, at ever more dear spreads, and oversubscribed demand. Argentina, a serial defaulter, recently issued a 100-year bond with a 7% yield, which was three and a half times oversubscribed. Tesla, an automaker, has yet to make a profit, nor has it produced positive cash flow in its brief history. Despite the fact that its debt has been rated below investment grade, Tesla was nevertheless able to sell a $1.8 billion, eight-year bond at a yield of only 5.3%. In June, Banco Popular, a failed Italian bank, was the first to be bailed out under the European Union’s new Single Resolution scheme. Credit spreads across the European bank sector actually tightened after the announcement.
Corporate indebtedness is higher than the 2008 peak. Corporate debt to gross domestic product (GDP) is now at 45%, higher than levels that preceded prior recessions. More troubling for the real economy is the use of cash, which is often used to buy back stock, fund merger and acquisition activity, or pay dividends. While shareholder rewarding activity continues, risks of re-leveraging are rising.
One measure, the ratio of internally-generated funds (free cash flow) to average corporate debt, is flashing warning signs. Historically, when this ratio dips below 20%, credit problems appear. Earnings growth, strong of late, is an important offset, and (if it continues) likely alleviates near-term pressure. Still, the risk/ reward tradeoff for lower-rated credit is unfavorable.
On the other hand, the tax-free market is benefiting from a highly favorable supply/demand equation. Lower net issuance, an aging population, and generally positive credit fundamentals have made municipals the best performer in fixed income year-to-date. However, this is coming off the rapid selloff after the U.S. presidential election.
Structurally, municipals are the best positioned market within U.S. fixed income. However, it is often fickle in the short term. Retail investor fund flows continually follow trailing performance in municipals.
As most municipal investors have long-term horizons and are primarily interested in tax-free income, these behaviors are counterproductive, and amount to buying high and selling low. Those counseling tax-free investors should be proactive in buying when yields rise. Most times a headline shakes the market, but underlying demand almost always produces a rapid recovery.
*An affiliate of Raymond James & Associates, Inc., and Raymond James Financial Services, Inc.
International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Past performance may not be indicative of future results. Investing involves risk including the possible loss of capital. Dividends are not guaranteed and will fluctuate.