What Does FINRA Know That We Don’t?
When it comes to bonds, I’m not sure much. Last Thursday FINRA took the time to send an “alert” out on what a rate hike could do to your bond portfolio. We will ignore for the time being that I haven’t seen them issue any warnings about the certificate of deposits with “range accrual” features or linked to inverse LIBOR or CMT. Somehow that is off their radar screen, while those notes are potentially toxic. I won’t even point out that what they really mean is a move in yields rather than a rate hike (which typically refers to the Fed increasing the overnight lending rate).
In some ways, it makes sense to send this warning. We have been saying for quite sometime that the investment grade bond market has limited upside if you own it on a yield basis. LQD is back to September levels on a “price” basis precisely for that reason. Spread tightening cannot offset moves in yields easily now that spreads are so tight. This has been another issue of ours. While many talk about spreads, most retail investors own corporate credit on a yield basis. We see continued outflows from investment grade (with the yield risk), into floating rate bonds and leveraged loans. These flows make some sense, though, we liked leveraged loans much more last year, and think the Fed isn’t raising rates any time soon, so would prefer to see spread products, like CDS become more available, as that is where we see good risk reward.
The warning also applies nicely to high yield. Not only do many high yield bonds have significant rate risk and reasonably high duration, another portion has negative convexity and no duration, meaning all the downside of high yield, with none of the upside.
While we agree that investors need to focus on duration (and we always do), FINRA may be pointing in the wrong direction, and being somewhat “alarmist”.
The 10 Year Bond
The current “on the run” 10 year bond was issued just last week. It has a “maturity” of 2023, but the duration is only about 9 years.
If you bought it today at 99.875 you would own the bond at a yield of 2.014%. Let’s say that yields “spiked” 1% tomorrow. For the bond to yield 3.014% today, the price would have to be 91.31. A loss of 8.56 points, not the 9 points forecast by duration. That is because of “convexity”. As the price of the bond decreases, and yields are higher, the duration actually shrinks. So the “risk” or how much the bond moves in price for every basis point change in yield, starts at 9:1 but is only 8:1 by the time the yield has moved 1%.
An 8.56% loss would be bad, but let’s now look at a 1 year holding period. So in 1 year, you would have earned 2% in coupon. Not great, but now the 1 year holding period return is a loss of 6.56 points.
But even that overstates the loss. In one year, the bond will only have a 9 year maturity and a lower duration. So in 1 year’s time, for the bond to yield 3.014% it has to trade at a price of 92.07. That brings the 1 year holding period loss to 5.81%.
In theory, we could finish right there, but let’s look at the curve. The current 10 year yield is the 2.014% we mentioned, but the 9 year bond yield is only 1.83%. So the “curve” is worth 18 bps. We live in a steep yield curve environment, and we typically talk about “parallel” shifts in the yield curve. So in 1 year, this will be a 9 year bond, and a 1% move in yields is really to 2.83%.
So on a one year holding period, a 1% move across the curve on rates would have a total return loss of 4.43% (or less than half of the instantaneous loss move of 9%).
So while the warning is useful, it is also useful to pay attention to curves and carry as bonds are a total return play as much as any other investment.
It is worth re-reading how scarce 10 year bonds are and why the Fed is so motivated to fight rises in the 10 year yield.
A Moderate Risk On Week
High yield performed well, most other spread products moved in line with treasuries, and treasuries were a touch weak. From our overall standpoint, we still think that some common beliefs are wrong and that Europe has more potential to spark another round of fear than most are pricing in. We go through the complexity of the fixed income market environment last week.
Sentiment versus Reality, or What is Priced In
Our assessment of what the real outlook is for various asset classes versus our sense of how people are positioned. Red indicates overvalued, Green is undervalued, and Yellow, is neutral. It isn’t exact. In our view, positioning and sentiment is more important, at least from a contrarian view. While it is possible to have strong support for an asset class with strong fundamentals still be a “buy” it is far more common to see sentiment diverge from reality and that is the opportunity.
On a quick glance, we are becoming more bullish on treasuries, munis, leveraged loans, as well as the CDS market. We like the fixed income cash bond market less, and EU Core should be a focus from the short side with Germany and France in the spotlight, although for different reasons.
Treasuries, Wednesday was a Great Buying Opportunity
Treasuries finished moderately lower on the week, but bounced nicely from lows on Wednesday and flirted with being positive on the week. We saw Wednesday as a good buying opportunity and recommended adding exposure, though we also though Thursday was ideal for some profit taking. We continue to believe that the market will get support on weakness as we outlined above, but as a quick reminder, the Fed continues to buy, there is limited supply, and so long as the Fed believes that energy and food price increases are “transitory” don’t expect short term rates to move up any time soon, and that will anchor treasuries. The data is okay, but not great, and there are a lot of positive influences on treasuries.
The Fed’s Stein issued the most interesting commentary yet, one I paraphrase as a “credit bubble warning” but he strikes me as too much of a voice in the wilderness to get too concerned here, and in any case, corporate bonds have the weaker flows and technicals.
Credit – The Bounce Before the Storm?
Credit markets saw some nice buying and spreads were tighter across the board. Floating rate products still attracted more investor interest than fixed rate products. I’m concerned that the “LIBOR Floor” and callability of leveraged loans is being missed by those investors, and while floating rate products would do well if the Fed starts raising rates, I don’t see that any time soon.
So far then investors are shedding some duration risk, but not really trying to profit from a changing environments (or trying, but are putting their money into vehicles that won’t deliver).
I have seen so much chatter at the retail level about $TBT that I am scared. It is a leveraged “investment” that attempts to produce twice the daily return of longer dated bonds. I think that leveraged ETF’s are horrible ways to play that view. Even if I agreed with the view, the path dependency there is too great and will likely cause more damage than necessary.
Munis did worse than corporate credit as they moved in line with treasuries. I still like the progress we are seeing in the finances of most municipalities and think the spreads are wide enough to overcome the rate risk, which currently seems overdone anyways.
Mortgage bonds had another “do nothing” week. That is good, I guess. The Fed is closely watching mortgage rates, and the 10 year bonds, as am I. Think there is more room for mortgages to run, but there are some serious supply issues, as in the lack thereof. The Fed really is buying up a large portion of the market.
EM Bonds – Currency War Declared
The local market debt looks like the way to invest here. With currency “wars” heating up, or at least every major country embracing QE programs, there is reason to believe local currency EM debt could do very well here.
Dividend Stocks as an “Other”
It seems like we have finally hit a nice bottom on NLY and XLU. We will be looking to add are also looking at some other areas including BDC’s as potential outperformers. With the “hottest” sector in the corporate arena being “middle market” lending, good BDC’s could be an interesting way to play that market indirectly, when few “direct” investments are available.
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