Rates Drop Rapidly Amid Inverted Yield Curve – Fixed Income Update

Markets tend to look at the yield curve in order to find clues as to what the expectations are about future economic growth and inflation. The yield curve is essentially the current yield on government Treasury bonds from 3-month maturities to 30-year maturities. At the end of May, the 1, 2, 3, 6 month and 1-year notes all yielded more than the benchmark 10-year bond. When shorter term bonds are yielding more than longer term bonds, it is known as an inversion or inverted yield curve.

Economically sensitive copper and oil prices fell in May, perhaps signaling weaker global growth activity. Such dynamics in the commodities market tends to push yields lower internationally. Some analysts believe that a continued escalation of trade disputes with countries in addition to China will crimp global economic growth and force the Federal Reserve to lower interest rates.

Total global debt as of the end of 2017 was $184 trillion, as monitored by the International Monetary Fund (IMF). Global bond yields fell in May with an estimated $10.6 trillion worth of debt now in negative yielding territory, the highest since 2016.

Some fixed income analysts are projecting lower yields later this year due to slowing economic expansion, continued demand for U.S. government debt, and an increasing probability that the Fed will eventually lower rates. (Sources: IMF, Treasury Dept., Federal Reserve)

Equities Give Up Early Gains – Equity Market Update

In stark contrast to the strong performance during the first four months of 2019, U.S. equities faltered in May as continued trade disputes hindered economic growth expectations. All sectors of the S&P 500 Index fell in May, with the exception of Real Estate. Technology and financial stocks experienced the brunt of the pullback in May.

May was the worst month since December 2018, when markets reacted to heightening trade fears and a possible rate hike by the Federal Reserve. Ironically, some analysts are expecting a reduction in rates by the Fed later this year in response to tariff reverberations and slowing economic global growth. A rate decrease by the Fed might lure equities higher as loan costs and capital remain inexpensive, thus buffering profit margins for U.S. companies.

Should a continued drop in rates persist, economists note that the U.S. dollar may weaken, thus boosting U.S. multi-national company earnings, which primarily operate internationally.

Global inflation expectations have eased considerably over the past month, prompting central banks in various countries to consider lowering rates, also known as growth stimulus efforts. (Sources: S&P, Bloomberg, Federal Reserve)

YIELD CURVE STEEPENING TRADE UPDATE

Last summer we issued a special report on a special type of corporate bond with a coupon that adjust based on the steepness of the yield curve.  The coupon is calculated using a formula which differs for each bond. As the yield curve steepens the coupon goes up and if it flattens the coupon adjust down.  As the yield curve flattened throughout most of last year the coupons were resetting lower each quarter until they finally hit zero last year.  Obviously, the prices fell precipitously as the coupons went to zero and these bonds were trading at in the $50 – $60 range – keep in mind these are investment grade corporate bonds that are issued by the largest financial institutions in the world (BofA, Citigroup, SocGen, etc.) and the quality of the underlying credit had not changed.  These bonds are generally marketed to retail investors at $100 and as one can imagine as the coupons fell and prices plummeted there was mass panic selling.   It was our thesis that the sell-off was overdone as the bonds were trading at significant spreads to the treasury curve assuming a zero coupon for life.  Bonds could be purchased at 4%+ yields assuming no coupon for the life of the bond which meant investors were getting an option for free.  The table below shows the current levels for the most commonly quoted curves:

The majority of yield curve steepener notes use the 2’s to 30’s or the 5’s to 30’s curves (#’s 15 and 20 in the table) and as you can see they are not only the widest curves but also both are currently the furthest outside their 1 year average. When we published our special report last year the 5-30 curve was 12bps and was -2.13 standard deviations its  historic average.  As you can see in the table above (second to last column on right) this has completely reversed and it is now +2.08 standard deviations its 1 year average.  At the time we issued the report we took a 10-15% allocation in client accounts and the bonds have since increased in value 10% -25% depending on the issuer, formula and maturity.  We are still holding our original position but are remaining cautious due to our negative view on credit spreads and the corporate bond market (discussed on the next page).

In May Jeffrey Gundlach (the new bond king), founder of Doubleline Capital gave an interview in which he said the corporate bond market could be heading for a collapse that would rival the sub-prime crisis of 2008.  And that while corporate bonds are not as over-valued as sub-prime mortgage debt was prior to the financial crisis, the corporate bond market dwarfs the sub-prime mortgage market and the overall exposure to investors could be the same.

If this sounds familiar to our regular readers it is because we have been echoing this thesis for over a year.  According to Gundlach, corporate bonds have been rich (expensive) by one standard deviation for most of the last 3 years and are now at an “outright sell” level.   He added that based on corporate leverage ratios, 38% of the corporate bond market should be rated junk.  The high-yield market is just as expensive as the investment grade market, Gundlach said, and spreads are totally inconsistent with corporate debt levels.  The chart below was from Jeffrey Gundlach’s DoubleLine Asset Allocation webcast for the month of November 2018:

This chart clearly shows spreads (the risk premium investor receive for buying corporate bonds) is not only historically low but that given the massive amount of corporate debt spreads are reaching stratospheric levels which are not sustainable.  The small stock market sell-off in the last quarter of 2018 gave us a glimpse into how quickly liquidity can dry up and bond spreads can dramatically widen in a high volatility environment and that was not even a major event.  We have written extensively in previous newsletters and illustrated how quickly bond prices can spiral downward in a high volatility environment.  In 2008 it was sub-prime mortgage’s that sent the markets reeling, the next crisis will almost certainly be caused by this combination of massive corporate debt and historically tight spread levels.

Gundlach went on to echo another theme of ours, that most of global GDP growth has been based entirely on the huge explosion of global debt of all types – government, corporate and even mortgage and consumer debt.  We have consistently beat the drum that this global debt bubble is almost certain to implode – it simply is not possible to continue to print and borrow money at these rates without serious fallout.  Considering the flat/inverted yield curve corporate bond investors would be wise reduce risk by either lowering their allocation to the sector of shortening the duration of their holdings.

Deciding When To Take Social Security – Retirement Planning

Deciding when to take Social Security benefits is one of the most important decisions one will make for retirement. You may either base the decision strictly on monetary benefits, or your decision may be more personally based.

The important question is when to start taking benefits, at age 62 or postponing benefits until age 66, or even later. The answer is different for everyone, as it depends on various factors such as health, lifestyle, and marital status. The amount of your monthly benefit depends on two variables, when you elect to start receiving them, and how much you’ve earned during your working years.

To determine how much you’ve earned, the Social Security Administration adds up the income subject to Social Security tax adjusted for inflation during your 35 highest-earning years. It then divides that total by 420, the number of months in 35 years. This figure arrives at your average indexed monthly earnings. The higher this is, the higher your benefits will be.

The Social Security Administration designs the benefit formula based on an average, so the same amount of lifetime benefits is calculated irrespective of when you begin receiving payments. The U.S. Government Accountability Office (GAO) explains this in a report on social security retirement saying “the Social Security benefit formula adjusts monthly payments so that someone living to average life expectancy should receive about the same amount of benefits over their lifetime regardless of which age they claim”.

When it comes to deciding as to what age to start taking benefit payments, various strategies and philosophies come into play. The calculated benefit amount per the Social Security Administration is known as the “full benefit”, in essence providing 100% of the calculated benefit due.

The caveat is that you need to be at least 66 years of age to take the full benefit amount. For workers retiring in 2014, the full retirement age is currently 66. However, if you elect to receive them earlier, then your monthly benefit is reduced for each month short of your 66th birthday. If you begin receiving them at age 62 for example, then your benefit will be reduced by 25%.  Conversely, if you wait until turning 70, then you’re entitled to delayed retirement credits, which increase your benefits by 8% for each year of deferment, capping out at a total of 32%.

So how do you determine the optimal age to take benefits and whether or not waiting may be worthwhile? A break-even analysis can be done, thus calculating how much more in benefits you may get, either by waiting for a higher benefit say age 70, or taking a lower benefit at a younger age such as 62.

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