It is no secret that the credit markets are near and dear to our hearts. The credit markets are not only where we cut our teeth as traders, but are (in our opinion) the most interesting area of fixed income. The credit markets combine the macroeconomic influences of the interest rate market (U.S. Treasuries) with the corporate volatility of the equity market (to varying degrees based on credit quality). It is our opinion that the credit markets require the deepest skill-set in the fixed income market and among the deepest in all of the capital markets.
Because the credit markets have so many moving parts, it is a place of diverse ideas and theories. It is not unthinkable for corporate conditions, changing business regulations and new tax policies to cause the credit markets to behave in ways not seen before. Such occurrences have the potential to blow up strategies based on historical models.
There is an old joke which states: Why did the man throw his clock out the window? He wanted to see time fly. We are throwing things out the window too, but it is not clocks. We are throwing out the idea that asset classes will behave during the forthcoming (eventual) Fed tightening the way they had in the past. Why might asset prices behave differently? Because conditions are much different this time. Ask yourself the following questions:
- When was the last time the Fed had a $4 trillion balance sheet?
- When was the last time the majority of the Fed’s balance sheet consisted of longer-dated securities?
- When was the last time the Fed had the Fed Funds Rate at, effectively, 0.00% (and held it therefore about six years)?
- When was the last time global interest rates were near 0.0% or negative as far out as 10 years on the curve?
- When was the last time that the population was aging the way it is today, driving the demand for bonds?
- When was the last time the Fed was tasked with normalizing policy five years into an expansion?
- When was the last time we saw the junk debt market double in size (growing from, roughly, $1 trillion to $2 trillion) while the ability of proprietary trading desks to maintain bond inventories were cut in half due to new financial regulations?
The answer to all of these questions is: Never.
To see a list of high yielding CDs go here.
As such, we must throw historical models out the window. We must do some actual work and look, not only into credit market capital flows, but where that capital is going and more importantly from where it has come?
What we have seen is that, during the past five years, there has been an increase in capital flowing into junk debt. It appears as though much of that capital is coming from non-traditional sources (investors who had not traditionally invested in high yield debt). This yield reaching has probably caused a good deal of capital misallocation (dis-allocation). We have mentioned this previously. We have heard an increasing number of fixed income professionals and Fed officials share similar opinions. This morning, former Fed governor, Kevin Warsh and Pimco fixed income strategist, Tony Crescenzi expressed similar concerns.
It is because of the aforementioned “unusual” circumstances (which pushed capital into areas of the markets where it had not been before and probably shouldn’t be today), that we do not agree with the thesis that high yield debt should be an outperformer when the Fed tightens.
Our concern is that when the Fed tightens policy, there could be a tightening of the credit availability. This could cut off credit for the riskiest corporate borrowers and/or make credit prohibitively expensive for other high yield corporate borrowers. This could cause an uncharacteristic credit spread widening as the Fed tightens monetary policy. In the past, high yield credit spreads tended to narrow during the early stages of Fed tightening as an accelerating, U.S. economy was a bigger positive for lower-rated corporate borrowers than higher interest rates were a negative. However, whereas the Fed usually tightens in the early innings of an economic recovery, it is now tasked with tightening during the seventh inning stretch. Although we do not believe the Fed will rain-out the rest of the recovery, monetary policy clouds could cause some investors to “take cover.”
It is a lack of fans in the stands which is a concern. Junk debt is considered “equity with a coupon” by most fixed income market professionals. Thus, junk debt is traditionally purchased for the purpose of speculation. For any speculation to work, there needs to be a ready liquid market in which bonds can be sold. This might not be the case with junk bonds and, especially bank loans. During the past six years, the size of both the junk bond market and the number of covenant-lite loans have doubled. At the same time, the ability of trading firms to trade proprietarily and hold inventory has been halved. This sets up a poor dynamic for junk debt investors, in our opinion.
Looking for Yield in All the Right Places
One potential way around this is to own actual bonds so as to hold until maturity or at least until market conditions stabilize. Unfortunately, in most cases, individual investors cannot own actual loans. Thus, they are subject to real losses (or profits) due to the actions of others.
When suitability is considered, there appears to be value in the credit markets. BBB-rated bonds is our favorite area of the investment grade market. Carefully selecting credits is imperative. Laddering or bar-belling portfolios can provide a good hedge versus rising rates while generating relatively attractive income. We caution readers against trying to “game” a Fed tightening by using past market performances. As we know, past performance is not an indication of future results.
Investors should not forget about municipal bonds, on both pre-tax and taxable equivalent bases. As our friends over at Cumberland Advisors point out, a spate of new municipal debt issuance has pushed spreads between municipal bonds and U.S. Treasuries wider. It is not uncommon to find even AAA-rated municipal bonds trading with pre-tax yields which are higher than those of U.S. Treasuries of similar maturities. As we have stated previously; for investors who can tolerate even a modicum of credit risk, high-quality municipals could be viable alternatives to U.S. Treasuries. For moderate risk investors, municipal bonds could make for viable alternatives to investment grade corporate bonds.
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.