It is getting easier and easier to write “Making Sense.” It seems that each and every day, incoming data are consistent with our overall outlook and financial publications are filled with articles which make reference to or support arguments which Bond Squad has put forth for more than a year. As such, our reports can be brief and concise. Today we will discuss credit market happenings, but first the economic data.
The July NFIB Small Business Optimism Index rose to 95.7 from a prior 95.0, but missed the Street estimate of 96.0. NFIB Chief Economist (and fellow Global Interdependence Center member), Bill Dunkelberg said in a statement:
“On the positive side expectations for business conditions and outlook for expansion accounted for virtually all of the net gain in July’s Index. However, capital spending reports continue to remain mediocre, spending plans are weak, and inventories are too large, with more owners reporting sales trends deteriorating than improving. As long as these stats continue to hold, the small business half of the economy will continue to not be able to pull its weight.”
The data, although better as a whole, were indeed quite “lumpy.” The numbers speak for themselves:
- 10% of employers think it is a good time to expand
- Employers anticipating job creation rises to 13%
- Percentage of firms expecting a better economy rises to -6%
- Firms anticipating higher selling prices unchanged at 14%
- Firms seeing increased capital spending rises to 23%
- Firms planning to boost inventory rises to 0%
- Firms expecting better sales falls to 10%
- Firms viewing inventories as too low falls to -3%
- Employers with jobs not able to fill falls to 24%
- Firms seeing easier credit conditions rises to -5%
- Firms expecting positive earnings trends unchanged at -18%
- Firms expecting compensation to grow unchanged at 21%
- 1,645 employers surveyed for the NFIB report
When the relatively low percentages of respondents who see “positives” are considered, the data do not seem very impressive. However, when we consider from where we were last year, even the -6% of firms expecting the economy to rise is impressive. Sales expectations fell to 10% of the respondents, firms expecting compensation to grow remained stable at 21%. This points to steady, if unspectacular, wage pressures.
The data indicate to us that the economic recovery is intact, albeit at a moderate pace. If more could be done to assist small businesses and encourage new business creation we might see more robust economic growth.
The JOLTS Job Openings report indicated that job openings rose in May to the highest level in nearly seven years. The number of positions waiting to be filled climbed by 171,000 to 4.64 million, the most since June 2007, a report from the Labor Department showed today. The number of unemployed job seekers per opening fell to the lowest level in six years. The JOLTS data might not garner as much attention in the financial media as do Nonfarm Payrolls, the Unemployment Rate and ADP private job growth data, but it is among the reports to which the Fed pays close attention.
Today’s data requires close scrutiny. For instance; the number of people hired cooled to 4.72 million in May from 4.77 million, pushing down the hiring rate to 3.4% from 3.5%. On the surface, this might be seen as a cause for concern, but this compares favorably to the average hiring rate of 2.8% during the previous expansion. Job openings increased at factories, construction companies and providers of business services and health care. The rate of openings climbed to 3.2% in May, the highest since August 2007, from 3.1%. Separations eased to 4.5 million in May from 4.55 million.
All things considered, the JOLTS data point toward a sustainable, but moderate economic expansion.
Batman and Robin (the Odd Couple)
An increasing number of economists, market professionals and pundits have come to the fore in expressing concerns about excessive risk taking in the fixed income markets. The latest missive comes from the unlikely duo of Martin Feldstein (chairman of the Council of Economic Advisers under President Reagan) and Robert Rubin (former Treasury Secretary under President Clinton).
The Dynamic Duo’s Op/Ed in today’s Wall Street Journal opines that the Fed should have “a realistic view of the breadth of the possible systemic risks and of the tools that are available to deal with such risks.”
Mr. Feldstein and Mr. Rubin remind readers that, as part of Dodd Frank legislation, the Fed’s regulatory reach extends beyond banks. The Financial Stability Oversight Council, established in 2010, “gives the Fed authority over certain non-banks, and can recommend policy changes to regulators like the Securities and Exchange Commission and the Commodity Futures Trading Commission.”
Following the June FOMC meeting, Fed Chair Yellen stated that the Fed could use “macroprudential tools” (Fed speak for regulatory authority) to deflate overbought conditions in certain asset classes. Our esteemed authors express the following concerns:
“First, since a wide range of assets and asset holders are involved, current tools are not nearly as broad and comprehensive as the existing range of systemic risks. Second, the situations are complex, making the design of an appropriate regime complicated and time consuming. Third, it might take considerable time for the FSOC and the relevant agencies to reach a decision to act.”
Anytime a regulatory authority responds to asset prices, it threatens to breed unintended consequences. However, the same could be said about monetary policy in general. What troubles us is not that asset prices might “correct” if the Fed uses “macroprudential tools” as price corrections are a part of aggressive investment strategies. Our concern is that many non-aggressive investors might be exposed to aggressive investments. Mr. Rubin and Mr. Feldstein share similar concerns. They write:
“Whatever the reason, the low yields on Treasury bonds have led to reaching for yield in many ways and in very large magnitudes. Again this needn’t mean that the asset prices are excessive, but the combination of their dramatic increase in price, the low volatility and the reaching for yield by investors and lenders suggest that the risk of excesses and the consequent instability have increased substantially. And if there are excesses, they represent wide-ranging systemic risks that go beyond the banking system.”
“There are many potential examples of heightened risks. For one, if hedge funds hold excessively priced assets that at some point start to adjust, there could be contagion and a snowballing effect, especially given the crowded trades that are common among hedge funds. That could affect broader markets and the economy more generally.”
The “crowded trade” is the liquidity crunch which we have written about often.
The article continues:
“The buyers of these instruments and securities include insurance companies, endowments, money managers, hedge funds, individuals, pensions, special funds created for their acquisition, and others.”
What is the extent of the reach for assets? The article contains the following data:
“The yield spreads on low-quality “junk” bonds have fallen dramatically. The volume of high-risk “leveraged loans” (i.e., loans that require interest rates of Libor, the London Interbank Offered Rate, plus 200 basis points or more) have increased from $200 billion in 2010 to $600 billion last year. Covenant-light loans have grown from $10 billion in 2010 to more than $250 billion last year. The S&P 500 is near record highs. Volatility across asset classes is very low and volatility instruments like the Vix index of equity volatility are trading at low prices to reflect this. European sovereign-debt yields have come way down, with the Spanish 10-year bond, for example, recently trading at the lowest rate since 1789. And the list goes on.”
We believe that investors have been sold a “Goldilocks” outcome, one which purports that interest rates should rise enough to result in increased income on floating rate loans, but not high enough to cause corporate default rates to increase. We believe that such a scenario is virtually impossible. Most floating rate junk debt structures have coupon floors. Short-term interest rate increases of about 100 basis points are required to begin to lift floating-rate coupons higher. A modest Fed tightening would do little to increase the coupons of floating-rate loans. A more significant rate increase could increase the incidence of corporate defaults.
Things We Said Yesterday
Since our days at Citigroup, we have stated our opinion that markets can trade on emotion in the near-term, but long-term performance is all about fundamentals. Mr. Feldstein and Mr. Rubin voice a similar opinion when they state:
“In the short run, markets tend to be psychological and in the longer run tend to reflect fundamentals. Whether and how much markets are mispriced relative to fundamentals is always uncertain. But when markets have moved across the board as much as they now have, that should be a warning of the possibility of excesses.”
It is our view that when cov-light loan issuance increases from $10 billion in 2010 to $250 billion in 2013, an overreach for yield by less-aggressive investors is a necessary component to such an expansion of glow-in-the-dark debt. As economic and policy conditions should normalize over time, so should asset allocations. When that occurs, bidders for risky credits may disappear. The result could increase corporate defaults without the Fed Funds Rate moving very high. After all, if a Fed Funds Rate of 2.00% to 2.50% is “neutral,” the 3.00% to 3.50% should be tight. We could see corporate defaults rise without the Fed Funds Rate becoming very “high.”
During the past few years, salespeople have focused on junk debt as a way to generate yield in an ultra-low-yield environment and protect against rising rates. However, Pimco data indicate corporate default increases lag interest rate increases by several months. I.E. rising rates tend to increase the rate of corporate defaults, so much for protection against rising rates from junk debt.
The Wall Street Journal’s, Spencer Jakab notes that capital outflows from junk debt appear more due to credit concerns than interest rate worries. He draws what we believe is a correct parallel between the recent pushback against junk debt deals with very tight credit spreads and few investor protections, and a similar investor pushback in 2007. He even invokes the words of Chuck Prince about the need to “keep dancing” while the proverbial music is playing.
Our take on junk debt outflows is that this is only the beginning. The pace of outflows might slow, but as the economy heals, capital should reallocate along more traditional lines. It could be that a 10-year Treasury yield of 2.75% to 3.0% and investment grade yields of 100 basis points higher are enough to pull capital out of junk debt. 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.
Moody’s (and S&P’s) Blues
For those of you who are pondering default rates among various corporate credit ratings categories, Moody’s and S&P historical data (cumulative through 2008) indicate the following:
Aaa/AAA 0.52% 0.60%
Aa/AA 0.52% 1.50%
A/A 1.29% 2.91%
Baa/BBB 4.64% 10.29%
Ba/BB 19.12% 29.93%
B/B 43.34% 53.72%
Caa-C/CCC-C 69.18% 69.19%
This data clearly indicate investors should not use deep junk debt for income enhancement. (1)
Three Dog Treasury
This is a big week for U.S. Treasury debt issuance as a new 3-year note, 10-year note and 30-year bond will be issued. Today the U.S. Treasury auctioned $27 billion of 3-year Treasury notes. The debt yielded 0.924%. The bid-to-cover ratio, which gauges demand, was 3.03, versus an average of 3.35 for the past 10 sales.
Indirect bidders, which includes foreign central banks, purchased 36.2% of the notes, compared with an average of 32.6% at the past 10 auctions. Direct bidders, non-primary-dealer investors that place their bids directly with the Treasury, bought 19 percent of the notes, versus an average of 18.6 percent at the past 10 auctions. The size of today’s auction was unchanged from the last three-year note sale, after declining by $1 billion a month in May, June and July. The U.S. sold $30 billion of three-year notes a month at offerings from October through April. The amount peaked at $40 billion from November 2009 through April 2010.
That demand was a little softer, particularly from direct bidders (which includes individual investors) is not surprising. Short-term rates should begin rising sometime in 2015 while less accommodative Fed policy and an ample demand for U.S. Treasuries should keep long-term yields fairly low. We believe that demand should be better for intermediate and longer-dated U.S. Treasuries.
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