“Another drag on long-term U.S. rates are low long-term foreign sovereign rates. The ECB will begin buying bonds on Monday, 3/9/15. Some investors might be encouraged to sell EMU sovereign debt to the ECB (at, near or below 0.00% yields) and purchase U.S. Treasuries to enjoy both higher yields and a strengthening currency. Money could also move from Europe into U.S. equities to take advantage of the stronger U.S. economy and a stronger dollar. Investors who panicked and sold assets into last Friday’s weakness are at risk of being “whip-sawed.” We would not be surprised to see prices of long-dated UST, investment grade corporate bonds and bond-like equities recover in the coming days or weeks as reality sets in.”
The yield of the 10-year UST closed at 2.24% on Friday 3/6/15. The 10-year UST yield closed at 2.19% yesterday and stands at 2.12% at the time of this writing. In spite of reported outflows from U.S. Treasuries by retail investors, the demand for U.S. Treasuries has picked up. With the ECB willing to purchase sovereign debt at negative yields, many holders of European sovereign debt are incentivized to sell. Where might they go with the money? A logical choice is the United States, specifically, U.S. Treasury securities. By swapping the 10-year German Bund for the 10-year UST, one increases yield from 0.23% to 2.12%. That is a yield pick-up of 9.3 times. At the same time, one can swap out of a weakening currency (EUR) for a strengthening currency (USD). Unless one must own euro-denominated debt, such a swap makes much sense, at least to us. This sets up a currency arbitrage, one which uses sovereign debt as the vehicle to place currency bets. Thus, ECB policy could (we believe should) drive the EUR to parity with the USD, if not beyond.
It is Bond Squad’s opinion that there should be ample (if not increased) demand for fixed income during the next decade or two. Although long-term yields should rise at some point, the current demand for yield and preservation of capital among investors and the desire of many central banks to foster very accommodative monetary conditions, should put enough downward pressure on long-term rates to moderate, limit or even halt (from time to time) their rise.
Things are Different Today
We would like to say that we are surprised by last week’s fixed income capital flows, but we are not. Lipper data indicate that $2.82B left the U.S. Treasury market last week. This was the biggest exodus from the space in about nine months. Investors have it in their heads that the Fed will tighten sooner rather than later, resulting in higher rates across the yield curve (if they give any thought to the yield curve at all). Most investors and investment professionals need to give thought as to how interest rates might behave on various spots of the yield curve.
At the same time, Lipper reports net outflows from equities and net inflows into municipal debt and high yield bonds. It appears that investors are ignoring warnings that new supply in the municipal market could drive down muni bond prices. This might be a good thing. The municipal bond market is the one area of fixed income in which retail investors can exert much influence. The population is aging and investment capital is becoming concentrated among investors who are entering a life stage in which income becomes a priority versus capital appreciation. It is because of this that Bond Squad believes that the demand for municipal debt could match, if not exceed the expected increase in new supply of municipal bonds.
High yield/junk debt is a different story. Recent capital flows data indicate inflows into junk debt. This is probably due to the much-heralded idea that junk debt does well when the Fed tightens. Bond Squad’s experience is that junk debt tends to do well during Fed tightening cycles in spite of the Fed tightening, rather than because of it. Junk debt’s traditional strong performance during tightening is partially due to a residual effect from low rates during the recently concluded Fed easing cycle, but it’s mainly due to the fact that U.S. GDP is usually north of 4.00%, 5.00% and even 6.00% when the Fed launches monetary policy tightening. Today we have the Fed contemplating tightening, albeit modest, with the U.S. economy growing somewhere in the mid-to-high-2.00% area.
Although Bond Squad does not foresee a meltdown in the junk debt market as a whole, we do not see it as an area of the market which may not deliver outsized returns. BB-rated high yield bonds might good ways for aggressive income-oriented investors to juice returns, when used in moderate quantities using carefully-chosen credits. However, there could be trouble in the nether regions of the junk debt markets, particularly among credits rated CCC and lower. Income from high yield debt is inherently less reliable than income generated from investment grade debt. As always, suitability trumps all other concerns.
In spite of the capital flows into high yield debt last week, credit/credit default spreads began widening at about the time market sentiment swung to forecasting a June Fed tightening liftoff. This runs counter to popular high yield debt strategy crafted over the years. That was then however, this now.