There is nothing on which fixed income traders can trade. Volumes are pitiful, there is nothing especially attractive in the fixed income markets and we appear to be locked into a trend growth economy in the United States. Japan remains stuck in a decades-long economic malaise and the Eurozone could join Japan in the land of misfit economies. Face it folks, the bond market seems priced to perfection. Until we have a clearer picture on Fed policy, economic growth and wage growth, traders could continue to manufacture volatility.
To see a list of high yielding CDs go here.
The Volatility You Take is Equal to the Volatility You Make
When Fed language is a bit less dovish, the bond market reacts. When Eurozone economic data disappoints, the bond market reacts. When Vladimir Putin or one of his minions says something (positive or negative), the bond market reacts. None of this should be surprising for market participants. At some point, Fed policy will be somewhat less accommodative. The Eurozone is an economic mess, it has been for many years. That the Eurozone economy is distressed should not be surprising to anyone. Only the degree of distress could be considered unexpected. As for Russia/Ukraine, the problem is not going away anytime soon. Neither side wants a major conflict. Although things could get out of hand, the current “limited conflict” could become the status quo for a long time, perhaps years. As none of these events should have been unexpected, market reactions to them seem disingenuous. It appears as though market participants are using exogenous events as excuses to generate volatility. Readers might recall that capital markets barely reacted to the Russia/Ukraine situation until a few weeks ago.
Fixed income market participants have all of this information at hand. However, they need volatility to be able to trade. Volatility breeds opportunity. If there isn’t any natural volatility in the markets, traders look so manufacture some. This is what we have seen during the past month.
Yesterday was Municipal Monday. As such, we have the following comments:
The Puerto Rico Electric Power Authority (PREPA) receive another, albeit longer, stay of execution. Last Thursday, PREPA announced it has committed to appoint a chief restructuring officer by September 8th, 2014 and to complete a five-year business plan by December 15th, 2014. PREPA said the agreement will enable it to use $280 million held in its construction fund for payment of current expenses and capital improvements, effective later this month. PREPA also reached an agreement with its banks to delay payments until March 31, 2015.
Although PREPA bonds rallied on the news, we are concerned that a business restructuring will necessitate a debt restructuring by PREPA. We remain negative on PREPA debt for all but the most aggressive investors.
All Things Must Pass
We have an overall cautiously-positive opinion on the municipal bonds space. Credit spreads have narrowed, particularly among highly-rated debt issues. At the present time, municipal bonds continue to offer attractive income opportunities for high-tax-bracket investors, but unless we see U.S. Treasury yields fall further, municipal bonds should be viewed primarily as income generating vehicles.
Not all is rosy in the high yield municipal space Citi’s Mikhail Foux said the following in a recent report:
“Meanwhile, investors simply can’t dismiss idiosyncratic credit concerns in the Caribbean region, and the ongoing volatility in the high yield corporate market, which could dampen demand for HY munis from crossover investors.”
We believe that the HY muni story has been mostly played out. With the Fed expected to begin tightening sometime in 2015, leveraged high yield municipal strategies could come under pressure from both higher borrowing costs for troubled municipalities and to fund leveraged speculations in the space.
In the municipal space, our focus is on revenues bonds (essential service, hospital revs and airport revs). Many state G.O.s can provide reliable income. We are less sanguine on local G.Os, s with other areas of the fixed income markets. We are in favor of moving up in quality in the municipal debt space.
Headlines during the past several days announce that some institutional investors have used the recent moderate selloff to pick up attractive bonds in the corporate junk bond space. These headlines might be taken by readers to mean that the worst is over for junk bonds. However, when one reads further, it becomes apparent that buy interest is far from robust and what buy interest there is appears to be focused in specific high-B to BB-rated credits. We discussed this last week. In the 8/12/14 edition of Making Sense we stated:
“We are on the lookout for asset price dislocations as capital flows out of high yield debt. There might be a dislocation developing in the BB space. Aggressive investors who can accept market volatility and can hold bonds to maturity might wish to consider select credits in the BB corporate bond asset class. Total return investors should probably consider opportunities outside the fixed income markets.”
Although we believe the best days for high yield debt are behind us, the selloff in high yield created some opportunities in the BB and high-B-rated areas of the market. We do not expect to see much in the way of price appreciation in high yield debt, but historical data indicate that BB-rated debt has a reasonable chance of maturing on schedule at par. The same cannot be said for debt rated CCC and lower.
We believe that articles which tout institutional investor interest in junk debt are overstating liquidity and activity conditions. Color we have received from our high yield trader contacts is that activity in the high yield market is “dead.” There is not much trading going on as many market participants are on vacation. We believe conditions will change following Labor Day. Our concern is that the capital outflows seen during July and early August will resume when participants and investors return from the beach.
For now, we see little urgency to commit capital slated for fixed income investing. We would rather wait for the Fed’s Jackson Hole, Wyoming conference and Labor Day to have passed.
Standing Next to a Mountain (The Grand Tetons)
Fixed income market participants are eager to hear comments made by Fed Chair Yellen and ECB President Draghi. However, their comments could be anticlimactic. We do not believe that Ms. Yellen will make comments alluding to a sooner-than-expected increase to the Fed Funds Rate. She will probably state that the Fed is in no hurry to tighten policy, but we do expect Ms. Yellen to warn on asset valuations. As for Mr. Draghi, he will probably talk a good game and re-state his commitment to hold the Eurozone together and to stimulate growth any way he can. However, the ECB and its policies are not what ail the Eurozone. If Mr. Draghi is permitted to launch asset purchases next month (not a certainty), it will probably be a positive for asset prices in the near term, but QE is not a long-term cure for what ails the Eurozone.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY
Director of Fixed Income
Wealth Strategies & Management LLC