It is often the case that what the Spec Ops troops at the front see conflicts with what the analysts back at HQ believe is happening or should be happening. Commanders who become overly-reliant on the “theoretical,” risk being overrun when the enemy thinks outside the box. A case in point is World War II’s “Battle of the Bulge”.
Lessons from military history apply directly to the fixed income markets. For more than a year, we have heard journalists, market pundits and asset allocation modelers explain away the bond market’s performance and conditions as the bond market misunderstanding conditions (I.E. “getting it wrong”). In actuality it was the economic and investment models which were “getting it wrong.” The modelers were back at “HQ” living in a theoretical environment. The bond market participants were living in the real world and were faced with real economic and market conditions, rather than those which exist in a textbook. The problem with economic theory and portfolio theory is that they are theories.
The Merriam-Webster Dictionary defines the word “theory” as:
“An idea or set of ideas that is intended to explain facts or events.”
“An idea that is suggested or presented as possibly true but that is not known or proven to be true.”
The problem is that theory has been confused with law. Physics has laws (as well as theories, such as String Theory), but economics and finance can only have theories. This is because markets and economies are comprised of human beings who can, from time to time, become fickle. Tastes, values and ideologies can change. Demographics can change. As any scientist can attest; change just one condition when conducting an experiment and you can alter outcome. This is true of investing and economics as well.
The challenge is to understand when conditions have changed. Quants failed to do this during the housing bubble. They (and their firms) remained wedded to their models based on historical mortgage performance. However, they failed to see that underwriting and property appraisal conditions had changed quite dramatically. They failed to acknowledge (or understand) what had changed. This was in spite of warnings from many MBS market participants. The mortgage specialists on my retail fixed income desk at Citigroup brought the deterioration in collateral to my attention in early 2006. Emails obtained by government investigators from the major credit ratings services indicated that analysts were aware that the quality of MBS collateral was deteriorating (but still assigned AAA ratings to many impaired structures, but that is another discussion for another report). What is not often discussed is that collateral details were available to quants, traders and desk analysts, as well as credit rating service analysts. Rather than do their due diligence, they took the AAA ratings at face value and applied mortgage performance models created when AAA-rated MBS was of a far higher quality in the past.
“You, who are on the road must have a code that you can live by. And so become yourself because the past is just a good bye” ~ (Crosby, Stills and Nash)
One would think that the financial industry would have learned from this experience. In fact it has, at least in the bond market. While many retail portfolios remain tied to models, fixed income professionals remain much more nimble. Thus, we have seen retail investor capital leave municipal bonds and pour into junk debt while institutional money has tended to do the reverse. We have seen investors shun investment grade U.S. corporates and U.S. Treasuries and favor emerging markets debt during the past few years. Meanwhile, institutional money has tended to do the opposite. Why the disagreement?
Increasingly, retail investors have had their money placed in model-driven portfolios which are based on conditions which do not (possibly cannot) exist today. They are married 4 to ideas that junk debt should perform well as the Fed tightens and that bonds should be inversely correlated with stocks, etc. However, these models ignore that the U.S. economy is transforming from one which experienced population growth from high birth rates and immigration to one which experiences population growth from longevity (longer lifespans) and immigration.
We feel there should be a greater focus on income and capital preservation than on growth strategies than any time during the past 60 years. Global demand for income is increasing and could remain higher than during the past half-century for the next generation, or longer. Thus, models which continue to call for a rotation out of bonds into stocks or greater risk taking by fixed income investors will probably be proved incorrect, at least for a long while. This sets the stage for another “conundrum.”
As what had occurred during the housing bubble, long-term rates might not rise in when the Fed raises short-term rates. There could (should) be enough structural demand for long-term debt, along with low inflation, to significantly mute long-term rate increases. Bond Squad has serious doubts as to whether or not we see the UST 10-year note yield break above 3.00% at any time during the eventual forthcoming tightening cycle. Except for a panic/model-driven/algorithm “tightening tantrum,” we might not see the UST 10-year yield break above 2.50%. Word on the Street is that hedge funds are building cash positions to take advantage of tantrum-driven higher bond yields. Thus, any selloff in bonds could be short-lived and prices/yields could rebound violently. The taper tantrum of 2013 might be a good precedent for what is coming down the pike. Bond Squad believes that the next tantrum should be less extreme then the tantrum of 2013, Investors who own actual bonds might be better able to weather a potential because of bonds final maturities.
Who’s gonna drive you home?
Do not underestimate the volatility which can be caused by a lack of liquidity in the bond market. Dealer desks cannot or (in some cases) will not provide the amount of liquidity they had in the past. There has been some talk of creating so-called “dark pools.” These are platforms in which so-called “buy side” firms (money managers, etc.) could buy and sell bonds with each other, thus reducing the need for dealers to provide liquidity. This sounds attractive, in theory. In practice it is not so easy.
The problem is that many fixed income portfolio managers with portfolios holding actual bonds, as opposed to derivatives, mostly own the same “go-go” (large and liquid) bond issues. If there is an exodus from fixed income by retail investors, it could be that most of these fixed income managers are all on the same side of the trade, the sell side. If most managers are on the same side of the trade, who will provide bids. It will probably be the hedge funds. Just as in 2013 (during the municipal bond rout), hedge funds could step in and buy bonds, but also as in 2013, they would probably wish to do so at significantly lower prices than what managers would like to see for their bond holdings. A snowball effect could take hold.
At some point, a few managers will probably have little choice but to hit these down bids. This sets a new price environment for these bonds and begins to be reflected in portfolio valuations. When investors see these lower valuations, they could hit the sell button. 5 This could push prices down farther. Like a snowball rolling down hill, the selloff picks up speed and gathers up more investors as it rolls along. Bond Squad believes that investors who own actual bonds and resist the urge to sell, should be able to ride this out. After all, as long as the issuer remains solvent, bonds should mature at par, regardless of what bond prices/interest rates do. As always, suitability trumps all other concerns.
A Question of Bonds
Media pundits and asset allocation strategists continue to be confounded as to why anyone, including institutions, buy bonds at current yield levels. The answers are rather obvious. Many investors, particularly actuarially-driven institutions, must own fixed income assets to generate income and preserve capital. Remember, most such institutions match maturities and duration to their actuarial needs. As such, they tend to hold to maturity (adjusting portfolio composition when necessary or advantageous). They are not trading bonds for profit nor are they using bonds for inverse correlation purposes. These actuarial investors include insurance companies and pension funds, both in the U.S. and abroad.
Another major fixed income investor class is foreign central banks. Central banks often purchase U.S. Treasuries to manage currency exchange rates and to effect monetary policies. This makes up what is known in the bond market as “sticky money.” This is money which must be in bonds no matter what. Pensions, insurance companies and central banks also comprise a group known as “indirect bidders” at U.S. Treasury auctions. Because of the influence indirect bidders can project on the bond market, their auction activity is closely monitored by fixed income market participants.
We believe that we are in a secular transformation of investment priority. Because of an aging population, it is likely that a greater portion of U.S. investor capital (both institutional and individual) should be focused on income generation and stretching investment principal as far as possible. Here is our opinion on some potentially-attractive areas of the fixed income markets, depending on client suitability and risk tolerance:
Lower-end investment grade and upper-tier high yield bonds: The demand for income should keep long-term interest rates fairly low. Thus, many investors will probably reach for yield. However, reaching for yield too far down the credit scale could prove painful. If the economy does not accelerate, it might be difficult to justify current junk debt valuations at the bottom of the credit scale. Thus, Bond Squad believes that BBB and BB-rated corporate bonds could become the focal point of many taxable fixed income portfolios. It has been our focal point for several years.
Municipal Bonds: Tax rates have increased during the past several years. This should increase the demand for municipal debt investments. However, fears of rising rates and municipal defaults have spooked many investors. If you can buy actual municipal bonds, they continue to represent attractive values for investors in the top two or three tax brackets. Municipal bonds are generally perceived to be safer, from a credit risk perspective, than similarly-rated corporate bonds. In fact, bank regulators are considering allowing banks to invest reserve capital in high quality municipal bonds. Insured municipal bonds might offer viable alternatives to Treasuries and GSE debt for some conservative investors.
Preferred Securities: Many investors like preferred securities because they can often offer more yield than corporate bonds issued by the same company. However, investors need to understand that the higher yield is not free. Preferreds sit near the bottom of corporate capital structures, typically subordinate to all assets other than common equity. Preferreds also tend to have long maturities or are perpetual. Thus, they can be very sensitive to movements in long-term interest rates. Although significantly higher long-term rates are not our base-case scenario, it must play a role in our thinking.
However, there are ways to moderate the punishing effects of duration in the preferred market. Bond Squad suggests considering the following:
- Preferreds with high coupons tend to have lower duration calculations than their low coupon brethren. Thus, the high coupon preferreds tend to provide a cushion versus rising rates. However, high-coupon preferreds carry with them a greater risk of being called away if rates remain fairly low. Thus, investors should be mindful of yield-to-call calculations.
- Fixed-to-float preferreds can generate high income and offer some protection against rising rates. However, they are not immune to interest rate volatility. Most fixed-to-float preferreds are perpetual, but float off of short-term benchmarks, such as three-month Libor. If rates across the yield curve move in a parallel fashion, prices might hold steady and coupons should rise.
However, if the yield curve steepens and long-term rates rise more dramatically than short-term rates, prices of fixed-to-floats can decline as coupons may not keep up with preferred market yields. If the yield curve flattens, fixed-to-float prices could perform quite well, but price gains are limited by the call feature. I.E. price increases are limited by the prospect of being called away at par. The closer a preferred is to its call date (fixed, floater or fixed-tofloat), the lower its potential premium if rates fall. Because a callable preferred (or bond) has the potential for greater price losses when rates rise than gains when rates fall, they are said to be “negatively-convexed.” Given our interest rate outlook, fixed-to-float preferreds with at least five years of call protection, five years of fixed rates, and floating spreads of at least 300 basis points over their Libor benchmarks might offer the best preferred opportunities.
- Senior notes with $25-par amounts might also offer opportunity for some investors. These notes are equal to (pari-passu) standard $1,000-par corporate bonds. However, like a preferred, they tend to be exchange traded and can be purchased in retail sizes. Because they are offered in smaller issue sizes than most $1,000- par bonds and some are not-rated, they often offer more yield than traditional corporate bonds. Many non-rated $25- par bonds are such because they are one of a few corporate bonds, if not the only corporate bond, issued by a specific corporation. Thus it is costprohibitive for a corporation to pay for a credit rating. If one is willing or able to 7 examine corporate financial data, one can often uncover attractive investments with moderate credit risk. Also, because of their smaller deal sizes and no credit ratings, they are often ignored by portfolio managers (large cookie-cutter SMAs, etc.). Thus, opportunities are out there for those who can do their homework and are not handcuffed by broad strategy mandates.
Humble Pie Charts
We favor portfolio diversification. However, we believe that diversification might be more important within asset classes rather than among assets classes. Should a 28-year-old growth investor own fixed income for inverse correlation purposes or otherwise? We would argue no, if the investor has a decades-long strategy. The last thing we would do is hedge out volatility for this investor. Any cushion you might provide during a market down-turn could be paid for by not being able to take advantage of a rebound or bull market.
Shift the discussion to a 48-year-old investor and the story changes. One could argue for a 30% or even 40% fixed income position, not only for inverse correlations to equities but to pad ones portfolio with income which could be used to invest in areas of the market when opportunities present themselves.
Move out to 68-years of age and you might want 70% to 75% fixed income in a portfolio, but here you really need bonds. At this time of life, return of one’s capital could be as important as return on one’s capital. You might need this principal in the next 10 or 20 years to pay for medical expenses, etc. Provided the bond issuers remain solvent, if one owns bonds with final maturities, one can clip coupons and still have their principal at a later date, regardless of what happens with interest rates. Maturities can be staggered or laddered, not only to manage duration risk, but to match potential future expenses (an actuarial-type strategy).
Our view is that asset class exposure should be targeted to the needs of individual investors, with some portfolios avoiding some asset classes altogether. However, within the client appropriate asset classes, diversification should reign supreme. As always, client suitability trumps any and all other factors.
We believe that the next three decades will be a far different economic and investment environment than the prior three decades. Navigating these uncharted waters need not be difficult. However, one might need to throw away old investment maps and chart new courses.
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.