Yields Move Up – Fixed Income Update

Treasury yields rose in September as the Fed indicated it would soon begin the task of reducing its holdings of government bonds. Additional influences on the bond market include tax proposals by the White House deemed to stoke inflationary pressures as well as better than expected growth data.

The fallout of the hurricanes on the credit markets seems inevitable. As insurance companies begin the process of paying out claims to those insured, they may need to liquidate holdings of corporate and government debt to meet payouts. In addition, the dire financial situation in Puerto Rico has left the municipal markets questioning how the country’s distressed debt may affect mainland municipals.

Comments from the Federal Reserve in response to any possible interference caused by the hurricanes suggested that the storms were unlikely to prevent the Fed from its rising rate trajectory or from reducing its $4.5 trillion balance sheet.

Sources: Federal Reserve, Bloomberg, U.S. Treasury

Bond Risk Review

Spreads in nearly every sector of the bond market remain near historic lows.  The “spread” is the compensation investors receive for the risk they take when purchasing a fixed-income asset and is expressed as a percentage or basis points over a comparable maturity U.S. Treasury (considered the risk-free rate).  The chart below  shows the historic option adjusted spread on investment grade corporate bonds.

As of this writing (10/12/17) the index is 1.03 which means investors are being paid a mere 1.03% over a comparable treasury bond.

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This chart illustrates the option adjusted spread for high-yield (junk) bonds:

This chart shows that investors are now receiving a mere 3.5% spread (350 basis points) over comparable treasury bonds.  As you can see, this is at or near historic lows and it means investors are not being rewarded for taking risk.  Remember, the investment grade index was 1.03% so investors are receiving  a mere 2.5% spread for investing in junk bonds over investment grade.  In our opinion, this spread does not accurately compensate investors for the additional risk they are taking for going down the credit curve and clearly the charts illustrate that this opinion is backed up by the historical data.

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This next chart shows the Moody’s Covenant Quality score which was developed to measure the change in bond structuring terms that will be detrimental to bond investors.

The index moves between 1 and 5, with 5 being the weakest covenant quality.  If we take these charts together, it becomes apparent that investors are receiving some of the lowest risk premiums in history while accepting historically poor terms and protections.   Subscribers to our newsletter will remember we wrote about the August Tesla bond issue which in our opinion could have very well set the high mark for investor complacency. The Tesla 8 year bonds came at a mere 5.3% yield and were unsecured.  The bonds also had no covenants regarding their placement in the credit structure should Tesla issue new debt in the future meaning that Tesla could issue senior debt that would have a higher claim on assets in a bankruptcy event.  Since their issue on 8/25/17, the bonds are already down about 3% trading at approximately $97.   We have written extensively in the FI Learning Center section on our website about the factors driving this yield grab mania but newsletter readers should understand that if they are invested in or are considering corporate bonds they face the real possibility of significant loss in value.  Given the tight spreads illustrated by the above charts and historically low interest rates it will not take a major event or market sell-off to trigger significant losses.  If we simply return to normality in rates or spreads corporate bonds (especially junk rated) could see major price declines.

Risk Off

We continue to advocate the risk-off trade in bonds and especially in lower rated corporate debt.  As we demonstrated above, the risk/return profile is one of the worst in history and investors should look to reduce exposure to corporate bonds and especially in the non-rated corporate bond sector.  Investors can reduce their exposure in several ways.  The easiest way is to simply sell their holdings outright and lower the percentage of corporate bonds in the portfolio.  We realize many investors reading this newsletter need the income and will be reluctant to  sell their holdings outright and luckily there are alternatives ways to reduce the risk within a bond portfolio.  One method is to simply shorten the maturity structure (duration) of the portfolio by selling longer maturity bonds and purchasing shorter maturity bonds.  As of this writing, the yield curve is extremely flat – the difference between the 2 year treasury and 10 year treasury is currently 77 basis points (less than 1%).  Therefore, an investor could move from 10 year corporate bonds to 2 year bonds and for a yield reduction of approximately 1%-1.5% (the spread on shorter bonds is lower than the spread on longer bonds).  However, the duration (price risk) on the shorter bonds is far lower than longer maturity bonds  which would greatly reduce the drop in portfolio value if rates begin to move higher.  Another way to reduce risk within a bond portfolio is to move up in credit quality.  As we showed previously in this newsletter, the spread between investment grade and non-investment grade (junk) is at historically low levels so the yield reduction for this rotation (while painful) is historically small and not nearly as painful as the drop in value investors could experience holding lower-rated bonds during times of higher volatility.  The final way to reduce risk would be to rotate from corporate bonds and into other fixed-income sectors such as MBS/ABS.

We see the ABS and MBS sectors as the most attractive and recommend rotating portfolios out of corporates into ABS/MBS.  We believe the MBS/ABS sectors provide some of the best value and have seen several large institutional investors selling junk rated corporates and rotating into similarly (or higher) rated ABS for a very small give up in yield.  By doing this trade investors can eliminate the company specific default risk inherent in corporate bonds and swap into an ABS backed by a diversified pool of hard assets guaranteeing the bankruptcy remote trust.  It is also important to understand that corporate bonds are (for the most part) binary in nature meaning there are only two outcomes – the issuer pays the bonds in full on the maturity date or it is bankrupt and the bondholders do not receive their principal back (perhaps some portion is returned after years of bankruptcy proceedings).  ABS and MBS are not all or nothing propositions, meaning that even if the underlying assets underperform depending on where an investor is in the credit and cash-flow waterfall it is likely they will receive some if not all of their principal back.

For smaller investors there are extremely attractive fixed-income options in the odd-lot ABS and MBS markets with small, investment-grade (or non-rated money good bonds) still offering 4%-6% yields.  In our opinion it makes absolutely no sense for investors to purchase bonds like the unsecured Tesla issue discussed earlier for a mere 5.3% yield (backed only by the hopes and dreams of Mr. Musk) when similar yields can be found in investment-grade bonds backed by hard performing assets.