Bond Market Insights July 15, 2015

Transcription

1 Bond Market Insights July 15, 2015 by Jerry Wiesner, CFA and Stephen Frahm General Bond Market Treasury yields rose during the second quarter as prices fell. The yield curve steepened, as long yields rose more than short yields. Treasury yields rose 9 basis points for two years, 28 basis points for five years, and rose 43 basis points for ten years. Bond yields rose sharply in late April/early May, and again in early June, before falling the last few days of the month. Ten year Treasury yields rose for the quarter, snapping a streak of five straight quarters when yields fell. The Federal Reserve continued to prepare the financial markets for a rate increase lift-off, which many on the Federal Open Market Committee (FOMC) expect to begin later this year. The June 17, 2015 FOMC projections showed many participants expect to begin tightening this year. However, the FOMC dot-plot projections reduced the median Fed Funds projection in 2016 to 1.625% and 2017 to 2.875%. Fed Chair Yellen also stated that once lift-off occurs, the pace of tightening will likely be gradual. Economic growth rebounded during the second quarter, but generally not as much as economists expected following a dismal first quarter. Employment improved as nonfarm payrolls added an average of 225,000 per month this year, and the unemployment rate fell to 5.3%. However, labor force participation was weak and the average work week averaged only 33.6 hours during the second quarter, which was down from Q1. Economic growth in Europe improved, although it is still lackluster, and growth in China and Japan slowed. Ongoing debt negotiations with Greece, and the rise and fall of the Chinese stock market added to financial market volatility. The Fed s preferred inflation measure, the core PCE, remained below the 2% stated target. Energy prices rebounded during the second quarter but only retraced a small part of the larger drop which began late last year. Wage growth remained modest, as average hourly earnings rose 2% over the last 12 months.

2 Central banks buy bonds for monetary policy reasons. The European Central Bank (ECB) continued their monthly purchases of European bonds for quantitative easing (QE). The ECB stated that they would not buy bonds with a negative yield greater than 0.20%; this declaration resulted in bond investors buying in anticipation of the EBC purchases. Many European bond yields fell further into negative yield territory, which made U.S. bond yields look attractive; this relative value resulted in increased foreign buying of U.S. bonds. The German 10-year Bund yield fell to yield only 5 basis points in late April, but then reversed and rose to over 1% in early June. This global bond market volatility greatly impacted the U.S. bond market, which followed a similar pattern for the quarter. Our Thoughts: Fed policy is data dependent. It appears that the Fed would like to raise rates off 0%, but have found reasons to delay lift-off due to low inflation, slower than anticipated domestic economic growth, and global economic and financial volatility. The Fed is generally reluctant to make any rash changes to interest rates while the economy is growing so slowly. The economic headwinds throughout the world evidenced by a commodity price slump provide further proof of a slowing global economy; the repercussions of a debt restructuring in Greece or Puerto Rice, or an equity market correction in China leading to slower Chinese imports, bolster the case for a go-slow approach. We expect the Fed to begin raising the Fed Funds rate before year end, provided that turmoil in foreign financial markets and foreign economies do not cause serious disruptions in the U.S. Even when the Fed begins the tightening process, it will likely be at a slow and gradual pace. The Fed Funds futures market is now pricing in an approximate one-in-three chance of a Fed rate hike in December. Although the unemployment rate has fallen significantly from its highs, other labor statistics (such as the labor participation rate) are not nearly as robust. The Fed is also focused on wage growth, which has been lower than expected given the labor market improvement. The ECB and the Bank of Japan continued QE by buying bonds, which in turn helps support our bond market by making U.S. bonds relatively more attractive. This foreign Central Bank buying will help keep a lid on U.S. yields. Bond market liquidity has been raised as a concern from some market participants. One potential reason for reduced bond liquidity is lower supply of high quality bonds due to buying from Central banks and domestic bank buying for liquidity reasons, as well as low dealer inventories due to capital and regulatory constraints. Another concern that as investors reach for yield in a low interest rate environment, they have purchased riskier and less frequently traded bonds. If many investors attempt to sell, prices may need to fall to attract buyers. SeaCap invests in high quality municipal and taxable bonds, which should remain relatively liquid. Also, SeaCap holds Government bonds in non-municipal bond accounts, which provide good liquidity.

3 Municipal Bond Market Rates have continued their slow rise over the quarter and nearly match the yield curve of a year ago; although yields in the 1- to 5- year maturity range are slightly higher, the magnitude is only about 20 basis points. Muni yields as a percentage of Treasury yields continue to be historically high. They are little changed over the quarter, 99% as of March 31 st versus 101% currently, and suggest attractive relative value for municipal bonds. The Barclays Intermediate Municipal 1-10 Year Blend finished June with a one month total return gain of 0.04% and -0.51% for the second quarter. The rise in rates led to larger price losses in long-dated bonds versus shorter bonds, the worst performing sector being the 22-year and longer maturities. New issue supply has slightly slowed from the rapid issuance clip at the beginning of this year. This year s monthly issuance has been greater on a year-over-year basis, resulting in a first half issuance total of $220.2 billion versus last year s $154.7 billion. The greater pace of issuance has been primarily driven by higher refunding activity, $145.4 billion versus last year s $81.0 billion. Pension underfunding continues to plague some muni issuers. Most recently, Illinois and specifically Chicago, are trying to relieve some of their stress with pension reform, but the Illinois State Supreme Court has rolled back their reforms. Chicago is not an issuer that SeaCap holds, nor is it an investment candidate. Puerto Rico, despite its proximity to the mainland U.S., has much in common with Greece as a bond issuer. Both have large debt burdens that are unsustainable with their current economic situation. Both rely on deficit financing to maintain their current expenditures and both are running out of cash. Both are looking to generous creditors to cancel some of their debts and to others who can provide bridge financing until their economies recover. SeaCap portfolios do not invest in Puerto Rico issuers. The drought in California and other western states has yet to impact local utility or general obligation credits. Most should have enough reserves water or savings to manage through another year or two of drought. A prolonged drought will heighten the costs of many issuers, who may not have the ability to pass along all their increased costs. Judicious security selection remains an important factor in SeaCap s investment strategy. Our Thoughts: The muni market is generally in a holding pattern until the Fed begins raising short-term rates. There was some movement of the short end of the yield curve higher, leading to continued steepness, in anticipation of the Fed s future actions. The volatility of rates over the past year reflects uncertainty over the timing and pace of future rate increases. The ratios between municipal bonds and Treasuries have kept fairly steady, and will most likely continue to remain as such until rates rise significantly.

4 SeaCap continues to structure portfolio maturities consistent with expectations for eventually higher interest rates. We believe rates will rise slowly over time, and thus a 4- to 5-year duration target is appropriate. Maturities over the next few years will allow us to take advantage of higher interest rate reinvestment. Buying during periods of price weakness, as well as yield curve roll-down in longer maturities, will be another source of alpha going forward. We will continue to seek out those creditworthy issues not affected by legacy pension problems and those who maintain appropriate reserves to survive temporary setbacks, be they weather- or economic-related. Taxable Bond Market The Barclays Intermediate Government/Credit index returned -0.62% for the second quarter. The Treasury yield curve steepened, and the Fed Funds rate remained near zero, which helped to anchor short yields less than one year. However, short yields should gradually rise as Fed lift-off gets closer. Corporate bond issuance continued at a heavy pace. According to Bank of America/Merrill Lynch data, high grade corporate bond issuance totaled $351 billion in the second quarter and $700 billion year-to-date through June. May issuance was a monthly record at $153 billion. Standard & Poor s 500 Index companies listed buybacks or dividends among the use of proceeds in $58 billion of bond deals in the past three months, the most on record, according to data compiled by Bloomberg. High grade corporate spreads widened during the quarter, which resulted in corporate bond sector underperformance versus Government bonds. Quarterly performance for corporate sectors was -1.18%, -1.24%, and -0.93% for intermediate industrials, utilities, and financials respectively, compared to -0.47% for intermediate Treasury returns according to Barclays index data. The duration (effective maturity) of the finance sector is about half a year shorter than the industrial and utility sectors. Our Thoughts: Corporate issuance has been strong and many issuers have taken advantage of low yields and issued in anticipation of a higher yields down the road. Many companies have reduced short-term borrowings and lengthened the maturity of their debt. SeaCap considers this as favorable for credit quality, which helps support our corporate overweight. However, net leverage based on net debt/ebitda is now at a fifteen-year high according to JP Morgan data; this demonstrates that companies have been willing to increase debt. Due to strong investor demand, there has been spread compression between higher and lower quality credits. Over time, many corporate issuers investment grade credit ratings have migrated lower to the A and BBB categories as the yield spread demanded by investors for companies to issue lower rated bonds is relatively narrow.

5 SeaCap may seek to opportunistically upgrade the corporate credit quality in portfolios. We continue emphasize A and high BBB credits. SeaCap expects the corporate bond sector to outperform the Government bond sector the rest of this year, primarily from higher interest income. When the Fed begins to tighten, corporate spreads may widen; we may seek to slightly reduce corporate exposure to wait for a better buying opportunity if spreads widen. Several corporate bond issuers that SeaCap owns have tendered outstanding high coupon bonds; the tender price has been favorable to our clients. Some investors are concerned of potentially higher yields, particularly when the Fed begins to tighten. A gradual increase in yields can be an advantage to investors as reinvestment of interest, calls and maturities are invested at higher yields. SeaCap continues to position intermediate taxable portfolio durations (effective maturity) at or below the mid-point of our current 3.5- to 4-year target range. We extended some shorter portfolios when the 10-year Treasury yield approached 2.50%. We plan to be patient for yields to rise before we extend durations to the top of the target range. Key Bond Market Indices Jun-15 YTD Index Total Return Total Return Barclays U.S. Aggregate Barclays U.S. Gov/Credit Barclays U.S. Intermediate Gov/Credit Merrill 1-10 Yr Corp/Gov ( A or better Corporate) Merrill 1-5 Yr Corp/Gov Merrill 1-3 Yr Corp Gov Barclays Intermediate U.S. Treasuries Barclays Intermediate Agency Barclays Intermediate A Rated Corporate Barclays Intermediate BAA Rated Corporate Barclays Mortgage Merrill TIPS 1-10 Year Barclays 1-10 Year Municipal Barclays Municipal Bond Source: Bloomberg

6 Source: MMD, Bloomberg DISCLOSURES The information contained in this presentation has been taken from trade and statistical services and other sources, which we believe to be reliable. We do not guarantee that this information is accurate or complete and it should not be relied upon as such. The opinions expressed herein are those of the author(s) at this date, are subject to change and are not necessarily those of Davidson Investment Advisors, Inc. This presentation is for informational and illustrative purposes only, and is not intended to meet the objectives or requirements of any specific individual or account. Past performance is not an indicator of future results. Indices provide a general source of information on how various market segments and types of investments have performed in the past. An investor should assess his/her own investment needs based on his/her own financial circumstances and investment objectives. Please note that direct investments in an index cannot be made. For more information, contact SeaCap at or SeaCapMarketing@dadco.com