Category: Bonds

I’ll admit it; I am a sucker for “too soon” jokes. Perhaps they are a welcomed over correction to spending most of the time complying with social constraints. Perhaps it’s just a character weakness. Either way, I like a comedian that will push the boundaries. Finance has it’s “too soon” moments as well albeit of a slightly different flavor.  You still might squirm in your chair a bit, but instead getting a good laugh, being too soon in finance forces a decision on whether it truly is too soon or just wrong.  Feel free to click here to read a March post I put up about emerging market bonds – a recommendation that was indeed a bit too soon.

Bond Process: Intermediate in nature

My general investment thought process and outlook doesn’t produce a ton of adjustments in fixed income. Rather than trying to navigate each smaller twist and turn, my process tends to identify those times when it’s time to take total conviction in a particular direction. Because these times are few and far between, it’s important to get the calls right.  More importantly, it is necessary to be able to admit and throw in the towel quickly when those calls are wrong. Three recent examples of such tilts have been heavily detailed here on this blog (congrats to the two of you who scrolled through the end). In August of 2016, the “tilt conviction” was to take a cautious stance on interest rate risk and last summer it was to begin piling into TIPS.  Both of those were very helpful in setting up the portfolio better than its passive investing alternative (the Barclays Aggregate Bond Index)

EM Debt: Wrong thus far

This last one from earlier this year in March, to include healthy doses of external (or dollar denominated) emerging market debt has certainly been wrong thus far. You can see in the chart below that external emerging market debt (blue line below) has a total return of –2.8%, vs a slight gain for the aggregate bond index and healthy gains for high yield debt. Central to this under performance of emerging market debt has been a couple of variables that I won’t dive in too deeply here. But, a) the current trade wars are a major threat to emerging market economies (in addition to ours) and b) the dollar has been extremely strong – which is also a headwind for the asset class. This has been a double whammy:

At this juncture, you certainly have to respect the fact that the outcome of our trade wars are uncertain – and really bad outcomes certainly have a probability greater than 0.  But, so do outcomes where the headlines were worse than reality and we are able to avoid the worst. What this means to me is that it is important to have some limits to how much exposure one has to the volatile group, but the case laid out in March remains intact. As such, I shall leave this call as too soon and stay the course with emerging market debt in the portfolios.

Summary of the case

A brief summary of the emerging market case is as follows: Many emerging economies have stronger growth outlooks than the developed world and are still in the midst of an upgrade cycle. So over time – we should continue to see the extra yield that emerging bonds carry will continue to compress towards developed world yields.  The improvements won’t happen in a straight line, but over time I still suspect there to be a long term convergence.

Also, these emerging market sovereign bonds have ratings that are superior to US junk bonds. But the extra yield an investor gets for stepping into junk is razor thin, leaving it less than appetizing to assume such risk. Since this March post, these yield differentials have moved back near 2016 levels – an area that was fantastic for entering emerging market bonds.

Key to this recommendation in its full was that the call for emerging market debt itself was independent of the duration/credit choices in portfolio.  It was simply that a portion of those risk allocations – whatever that may be for you – should be coming from emerging market bonds. Again, it should be limited it because the trade risks are real, but should still be “overweight”.  In FEG’s case, our overall duration for fixed income in our balanced model is 4.9.  But, Emerging markets make up about 15% of that duration.

Perhaps soon upping the ante:

One caveat I wish to submit now vs. the March review is the focus on dollar denominated / external debt. Back in March – it was made clear that the argument was being applied only to US dollar denominated debt so as to be more insulated from currency risk.  Local currency debt is in the chart above as orange – shows the pretty steep losses in these bonds as they have been punished. But, the US dollar has been on a very strong multi-month expansion.  Sentiment on the dollar has turned very, very bullish – and that can often be time to begin moving more towards a contrarian stance.  A softer dollar would take some pressure off many emerging economies in general, but it would have a much stronger impact on local currency debt. We aren’t quite yet to the point of fully make that adjustment from external debt to local currency – but are getting close. If it can turn the corner in the coming weeks, it could very well be worth the risk to move on out to this local currency denominated debt.

 

After the recent onslaught of bonds, right now is the perfect time to re-sharpen the battle plan and be ready to make further adjustments to the portfolio.   This rout in bonds has emboldened speculators to accumulate record short positions on US treasuries as yields approach 3%. Especially if a pattern of demand can be established in 10 year treasuries near the 3% yield mark, we need to consider taking a bigger step to the opposite side of this position. Time and again, history shows us that it can be quite lucrative to take the other side of speculative positions when they reach extremes like this.

In our portfolios, we haven’t owned a ton of bond risk (interest rate risk nor credit risk) over the past couple of quarters. However, we did pick up a bit more duration in January – which turned out to be a wee bit early!  The point of this note is to explain why a good chunk of both of these bond risks in our portfolios is obtained through emerging market bonds (EMB and PCY) and why they could even be in line for an increase.

These bonds contain a little more duration than the Barclays Aggregate Bond Index – so containing it in the allocation does marginally boost interest rate risk – if that is what you are looking to do.  The credit risk is still a compelling one for these bonds on a risk adjusted basis.  Here are the main reasons:

The case for emerging

1. Many emerging countries are earlier in their credit cycles – whereas US is late to quite late with interest rates now very clearly on the rise. This reality of these rising rates has put pressure on bond prices and over the past 6 months or so has materially offset coupon income.

In some cases, like in Argentina interest rates are also on the rise. But in many cases – rates are either static or following.  Here is a chart of some of the major issuers in the emerging market bond (US dollar denominated) index which shows rates generally on the decline since early ’16.

2. The credit upgrade / downgrade cycle still has better odds of favoring emerging country bonds as opposed to developed.  Among the top issuers, the overall movement is pretty much a neutral with some having moved up and other moving down.  However, the picture for developed countries is quite different. In 2011 – the US was handed the S&P downgrade bombshell.  Joining the US in downgrades are developed nations like the UK, Spain, Italy, France and Japan. Pretty much fiscally conservative Germany stands alone in remaining intact.

Moving forward, I believe it is quite reasonable to assume there will be continued convergence in the ratings among developed and emerging bonds.  If that is the case, we should expect the bond yields to also converge (which of course means investors will be better off in the higher yields offered in EM bonds today).  The reason for this belief is underpinned by a couple of key facts: First, many of these emerging economies haven’t taken on the debt that the developed world has.  Secondly, they should also continue to grow their economies at a more rapid clip.  Middle classes should continue to broaden out, as does the tax base. These are all good things for the underlying credit quality of the countries’ bonds.

In the short run, of course, this asset class can be prone to a crisis – and capital can flight to perceived shelter in these developed country bonds.

3. Further insight can be obtained into EM attractiveness is comparing their yields to junk bonds. Junk bonds offer clearly inferior credit profiles to the sovereign bonds, yet have yields that are now only modestly higher. The weighted average rating for the EM bond index is about a BB+, vs. a B+ for the junk index. Meanwhile, the yield premium for junk has moderated through this cycle to a much more reasonable level.

The warnings

This investment case doesn’t come without some warnings. The first is that overall bond duration should be carefully managed. Having shot up near 3% – and having so many speculators short bonds – this is an interesting spot to pick up interest rate risk if some level of support can be established. As we move past the short run though, higher nominal GDP, massive US treasury issuance and a federal reserve in reverse should continue to pressure yields higher. This argument is simply that whatever your duration level is, a significant portion should come from EM Bonds.

The other cautionary tale is the real froth that has shown up in the riskier segments / frontier bonds. In2017, issuance soared in emerging market bonds, with nearly half of it coming from junk issuers.

The debt markets in 2017 clearly showed some froth – and this could be a poster child. But, I still wouldn’t let that keep me from owning higher grade EM bonds. Yes, I absolutely would and do keep credit risk at a minimum at this point where there is very little yield cushion for when things go wrong. But, a good chunk of the credit risk I take would again – come from EM.

Bottom line: after a little correction here, emerging market bonds (US dollar denominated) should be at the top of your shopping list.

 

I’ll be the first to admit that the stock run-up and crypto craze are certainly far more exciting topics.  The stock run up has been thrilling and has moved to some pretty significant extremes in sentiment and certain technical measures.  My equity thoughts are generally quite long term [feel free to check out the November post on relaxing a bit on valuation multiples].  But we are at a point where I highly recommend that you make sure to follow my colleague Andrew Thrasher, CMT at athrasher.com for some excellent context on these recent sizable stock moves and what they mean going forward.  As for this post I will be going in another direction and sticking to the more boring stuff and where I think I can add some value.

Last summer, I put out a lengthy piece explaining why it was time to begin allocating towards inflation protected bonds (TIPS) for at least part of your portfolio. I won’t revisit the details or foundational work, but will provide a quick update as it is vital to pay attention to the nickels and dimes that can be gained through active bond management.  They add up over time! A quick summary of the summer’s thesis was that while TIPS had been a miserable place to have been invested since late 2012, a few solid reasons were presented as to why it was time to begin putting some money there (a new argument at the time for me and FEG).

Fast forward the beginning of this year and we are finally beginning to see the possibility of inflation hit major financial publications like the Wall St. Journal and Barrons. The attention has been there because several commodities ended 2017 quite strongly and inflation breakeven spreads have moved back above 2%.

Again, I’ll leave the details and foundational work to the August article, but, in a nutshell TIPS bonds are where you want to be when the breakeven spreads are rising, because that means the yields on regular bonds are rising faster (and thus, prices underperforming). In other words, 10 year treasury bonds have taken quite a hit over the last several months while TIPS have been generally stable. You can see that probably in a more straightforward fashion on the chart below.

While TIPS have certainly been a major upgrade relative to their nominal brothers – there has still been a slight income shortfall to their corporate cousins.  Investors have still been better off with the higher yields earned by corporates. However, this income advantage has been at a much lower run rate than it had been – meaning it has been that costly to hold the safety of treasuries.

In summary – we have been quite pleased to have started and subsequently increased our position in tips. Around 2% was where the breakeven advance had stalled the last time, and we should expect at least a little stall or pullback here. But over the intermediate term I would expect inflation protected securities to remain strong at this part of the cycle. Along with these increased market based expectations a few other signs (PPI vs. CPI, a few commodity rebounds and slow but steady increases in wages) indicate this to be the case as well.

Last November, most financial markets had to quickly re-calibrate to new and unexpected formulas resulting from the election landslide. The stunning rise in yield for the 10 year US Treasury bond from 1.8% to 2.6% in just a few short weeks captures the essence which is centered on the potential for nominal GDP to break on through to higher territory. This higher nominal GDP balloon was filled with the air of moving higher on both its underlying parts: higher real economic growth (real GDP) AND more inflation as more activity could finally get all this money sloshing around.

Fast forward several months and this balloon didn’t as much pop as it did find a slow but persistent leak. A sudden collapse in cell phone prices and oil suppressed by OPEC cheaters and US shale producers has played a role. But so has a reduction in the prospects for the infrastructure spending and tax cuts that led to air in the balloon in the first place. Last week’s continuation of weak inflation has cast more light on the current disinflation trends. However, I believe this is a good spot here in mid – August to take a step back and evaluate – specifically within a fixed income context. Cutting to the bottom line, this is a good spot to have exposure to Treasury Inflation Protected Securities (TIPS).

The Granddaddy of Measuring TIPS  Value….The Breakeven Spread

To begin making any case either for or against TIPS, I must start with break even spreads. Break even spreads are simply a calculation that tells you how much inflation would be required to make the returns on a TIPS bond equal to that of its unprotected (and higher yielding) counterpart. The straightforward calculation is simply the difference in yield between a regular US Treasury bond and one that is of the same maturity but protected by inflation. If a regular old treasury bond yielded 2.0% and a TIPS bond yielded 0.0%, then the break even spread would be 2%.  Thus, if inflation then proceeded to equal 2% over the life of the bond – the investor would “break even” by having an equal return on both bonds.

To take it a step further, we then think about the recent trends (last 5 years charted below) and how TIPS have performed compared to regular treasury by monitoring whether this spread has been moving up or down. As the spread moves up, you are better off in TIPS as it means the yield had to rise faster in nominal bonds (and prices down faster) and vice versa of course on the way down.

Failed to Break Even

TIPS have been the beets in the smorgasbord of bonds. They are certainly on the buffet as an option, but putting them on your plate has done nothing but stink it up.  Like a smorgasbord, you just don’t to take one of everything. I realize this isn’t a perfect analogy since there are plenty of folks (like my 11 year old son) that love beets.  But, you get my point – that for a couple of reasons TIPS just haven’t been the place to be.

The first reason is due to a drop in the pricing of the “I” part of TIPS which can be seen in the chart above shows as the break even spreads fell from a range above 2 to one well below.  Again, the only way this happens is by the prices of regular bonds outpacing those of tips.  Thankfully, in FEG portfolios, we began exiting a rather healthy TIPS allocation in ’12 and were fully out in early 2013. Owners of TIPS got a rather healthy and nice pop during the middle of 2016 before just exploding last November, but generally speaking; they haven’t been the place to be.

The chart below shows it more clearly with the total returns from the major types of bond ETFs over the past 5 years. Investment grade corporates (LQD) have brought home over 20% cumulatively while TIPS are bringing up the rear with barely a positive return!

This leads me to the second source of TIPS underperformance: the “T”.  During relatively healthy economic and financial conditions it pays to earn the corporate spread by taking on credit risk of over just being in treasuries.  Taking it one step further, it pays even more as that spread drops, meaning relative price appreciation for those owners of the bonds.  This is what we’ve seen continue as of late to the point where investors have begun to compete with one another to take on corporate risk, handsomely rewarding their owners (including those in FEG portfolios)

Going Forward

Re-iterating the punchline, most of this has been a recap of the rearview mirror but as of late – TIPS have made more sense to me as of late for a couple of reasons that I will attempt to unpack.  Perhaps not yet to a full blown large position, but it’s time for at least a small, diversifying way. Why? For me, it’s always about the price – the inflation outlook doesn’t have to be great, just better than suggested by the price. And I do think that’s the case here where at least a decent pitch can be made for at least some inflation.  Lastly, it is the razor thin corporate spread to be earned by being in corporates over treasuries. Investors just simply don’t have enough cushions by taking on corporate risk.

Money Supply Should lead to Brighter Outlook

One thing that leads me to believe the inflation outlook should be brighter than currently given credit is going old school and simply looking at broad money supply measures.  As seen on the following chart -throughout the 60’s, 70’s & 80’s – M2 (the macro econ 101 money supply measure counting cash, checking and savings accounts) steadily hovered around 55 to 60%. Just for the econ readers – I think it’s pretty safe to say we can see Milton Friedman’s hands in matching money supply to economic growth.

However, this dropped throughout the 1990’s thanks to a booming productivity and technological advances that could spread money around faster. The Greenspan-Bernanke-Yellen activist central bank regime however has been working ever so hard at taking our money supply to new heights (as a percent of the economy).

What’s this got to do with inflation? Taking the chance to mention Friedman a second time, it was he who taught us that inflation is always and everywhere a monetary phenomenon. After all, in an effort to keep it simple enough – inflation is really just about too much money chasing too few goods. It’s certainly possible this last and big leg up in the money supply could indeed lift inflation. The relatively low money supply in the mid 90’s and early ‘00s was certainly coincident with low inflation.  The following chart is the same as above with M2 as a % of GDP but has an inflation overlay (set forward 5 years under the thought that it takes time in reality for things to run through the economy). Both measures are smoothed by taking a trailing 12 month average.

Using M2 is an inflation predictor is pretty far from perfect. For instance – the money supply can “go up” for odd reasons. 2008-2009 was a classic example as people were selling assets and parking money in their bank accounts which boosts m2.  This isn’t money that is likely to be circulating in the economy and creating inflation. But, nothing is going to be perfect because if there were – we’d be far better at predicting it and profiting from it.

It’s easy to see at least a loose relationship (for the math junkies an R squared of about .3).  I don’t know any more than the next guy if we can break free from this 2% range back to the more historic norm of 3%. Furthermore, we find scant evidence that any of the global deflationary forces (technology, excess capacity) have dissipated. The key for me though is that the market pricing for inflation respects the latter and gives virtually no probability to the former. This is why it’s a reasonable time to grab some protection / diversification through TIPS.

Another worthy criticism of M2 is that it is too narrow in an evolved financial economy for use in an analytical context. I can’t argue with that, but M4 – a measure put together by the Center for Financial Stability – can also be seen to be growing a faster clip recently.

Under the Umbrella and close to the Handle

Going back to the other factor that has kept TIPS a big underperformer has been the corporate spread and the power it has given to the outperformance of corporate bonds. However, that cushion has fallen to razor then levels – with an A rated US corporation providing only 1% more yield than a US treasury. It’s still higher compensation, but there’s also much less cushion for when we get a de-risking and much less upside as it compresses from here. While A rated corporate bonds provide you a protective umbrella, treasuries get you closer to the handle. I can’t tell you what would cause spreads to move back to a more normal level or when that would happen. I can just tell you, the margin for error is small and that it’s at least worth mentioning that the Fed has announced they will begin their Quantitative Tightening program (QT).  Quantitate Easing (QE) could easily be argued as a factor to keeping spreads tight.

Conclusion

This case may not apply to every portfolio, so take it for what it’s worth and what it may mean to you. This case for TIPS is certainly meant to mean more to those that have significant fixed income exposure. Fundamentally – whether it’s here about TIPS value or elsewhere its more about the price and many have given up on TIPS. Said another way another move up on the reflationary trade may not happen (odds certainly don’t look that bright at this point), but the point is you aren’t paying that much for protection if it does.  As a last thought, I think about what it would mean if M2 were to slow way down and revert back to its longer term mean as a % of the economy. If the money supply / inflation relationship were to correct this way, I would certainly worry about the appetite for things further down the risk curve like corporate bonds.

This past summer, I put up a (admittedly rather boring) piece on the concerns I had for bond prices.  To be clear, the article contained no prescient points about the ten year returning to 2.2% well before year end! I would like to take credit for such a call, but that was not the case. If it were, the article would have called for a more extreme de-risking in bond positioning – perhaps even to a net short extent.  Instead, the case was based on a few data relationships that suggested the US we were susceptible to a shock in rates.

Recap of the shock risks:

Those three concerns were:

• Interest rates on 10 year bonds had stretched way below trend in their relationship to (core) inflation – as far off trend as any point going back to 2013.
• Historically, there is a tight relationship between nominal GDP (the growth rate in the economy before backing out inflation) and the level of 10 year interest rates.
• Despite the common narrative that the US was a “high yield” play , US real rates were actually lower than they normally were in relation to the EU & Japan on a real interest rate basis.

(For a more detailed account of each of these factors you can click here to read the full blog post   https://adamharter.com/?p=43)

Update to those shock risks:

• After being stretched to nearly -1% (using core inflation to compute), real yields have bounced back up towards 0. However, real yields would still need to move up about another 30bps to reach their 5 year average.

It should be noted that core prices could easily moderate over the next couple of months and do their part to boost real yields without a further move up in outright level of interest rates.

• The jump in rates has only made the first step towards converging to its long term relationship with nominal GDP.

• Global yields have moved up in tandem which does not really change the relative value of US bonds to their EU and Japanese counterparts.

 Where does that leave us for positioning?

Longer term – we really do need to be cognizant of the possibility that we are amidst a sea change in market environments. I’m not just talking US politics here and the potential for budget deficits that lead to inflation.  Other factors were already stepping out of the batter’s box.  Namely, as the US retires 10,000 workers a day – those boomers will be shifting from the accumulation phase of finance to the distribution (whether that is through pension or private savings).  These factors, coupled with the underlying relationships above, suggest we may just be through the first 2 or 3 innings of the adjustment process

Shorter term – there hasn’t really been enough time for 2 or 3 innings of the adjustment process and there is plenty of opportunity for things to settle down.   In my estimation, way too much certainty has been quickly built into these probable inflationary/higher rate scenarios. If so, that leaves plenty of short term room for probabilities to adjust, allowing bond investors to stabilize their principal while earning their coupons.  Just maybe, we even get a Santa Claus rally back up in price for bonds.

As we go forward, a lot will depend on what ultimately happens to nominal GDP.  Jeff Gundlach talked in his weekend Barron’s interview about the nominal economy getting back to 4, 5 or even 6%.   The difference between the upper and lower of these levels (4 or 6%) would mean significantly different return outcomes for bonds.  A lot also depends on the amount of time it would take to get back up there.  As of now, in late 2016, I think a key point is that we aren’t going to get there all at once.  We can use the short run to collect coupons, perhaps make a tactical trade to the upside, and prepare the portfolio for the forthcoming innings.

I write this from the perspective of one who has generally benefited (i.e. maintaining significant bond exposure) throughout this cycle by riding the wave of lower and lower interest rates. Many times along the way, though, it has been tempting to join the annual calls that we have reached the end of the ride and that higher yields are around the corner.  Again and again, yields made new bottoms and made us thankful for owning normal fixed interest rate bonds. From my seat though, we have reached a point that warrants a serious consideration for interest rate risk.

I point to a couple of things that point to the current risks – none of which are directly related to US Federal Reserve interest rate hikes.  I would note however that I do think there is higher than market consensus odds for hikes in 2017.

Negative Real Rates

The first threat I point to is that of yields on 10 year US treasuries again falling below core inflation. We call this a negative “real” interest rate.  This isn’t unprecedented, but past instances of negative real rates were short-lived. Yields have been chasing inflation lower since Federal Reserve Chairman Volcker dropped the hammer in the early 1980s.  We are now as far off trend as at any point since the months leading up to the big 2013 correction!

The measure of inflation here, Core Consumer Price Index (CPI), might very well moderate as we move through the back half of 2016, but the low yields suggest a good portion of moderation is already to be expected. The risks at this point are that we edge back up in real yield, a good portion of which could come from higher nominal rates.  The regular or “headline” Consumer Price Index (CPI) gets a lot more attention and for good reason.  With headline CPI much closer to 1%, the “real” real yields aren’t yet negative at the 10 year mark.  However, as the impact from the collapse in crude oil fades, we might just see core and headline meet somewhere in the middle and closer to 2%.

Bonds & the economy: relationship restoration

The next factor I consider is the long-held relationship between economic growth as measured by nominal Gross Domestic Product (GDP) and the yields on 10 year bonds.  Nominal GDP growth measures overall growth before they subtract out inflation to get to Real GDP.  Demographics in the US have shifted this trend down slowly over time as boomers have moved from being borrowers to being savers. Still, the relationship between nominal GDP and 10 year rates has been fairly tight over time.  Instances where the difference went much beyond +/- 1% were quickly corrected. Runaway inflation in the 70’s took nominal GDP super high – a sort distortion to the relationship that could happen again. But I wouldn’t make that a base case and I doubt that would be too kind to bonds, either. With a nominal GDP of around 3.5% and a bond yield of around 1.6% the difference is approaching 2%.  This kind of stretch is near the highs of this generation and we could certainly either see the economy and/or inflation soften without much give in yields, or we could experience a shock higher in rates.

“But look at Japan and Europe, the US is High Yielding”

A common argument for hanging in there with treasuries is the comparisons to the rest of the world. The argument is an appealing one that suggests that rather than earning less than 0% in Japanese Government Bonds (JGB’s) or German bunds, you should grab the 1.6% still available in the US. While racing out to earn a negative yield in those foreign bonds shouldn’t be in the cards, I don’t think the argument fully appreciates the significance of investing in different currencies with potentially vastly different inflation and growth characteristics.  The chart below compares the differences in “real rates” (like is done above for the US) among the US, Japan and the EU as a collective.

The deflationary drag in these countries shows that rates are low in these countries for a good reason.  Based on this relationship, we are actually lower than norms would suggest!  Though we could hover lower in real rates for some time, hopefully this at least throws a little cold water on the “US is a high yield” thesis.

Together, these factors don’t provide me with a case to go outright short bonds or even all out of bonds. However, they firmly warn me, and perhaps you, that we are susceptible to a shock in rates higher.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.