Advanced Income Solutions LLC October 2017 Newsletter
Market Update
(all values as of 09.30.2020)

Stock Indices:

Dow Jones 27,781
S&P 500 3,363
Nasdaq 11,167

Bond Sector Yields:

2 Yr Treasury 0.13%
10 Yr Treasury 0.69%
10 Yr Municipal 0.84%
High Yield 5.77%

YTD Market Returns:

Dow Jones -2.65%
S&P 500 4.09%
Nasdaq 24.46%
MSCI-EAFE -8.92%
MSCI-Europe -10.53%
MSCI-Pacific -6.19%
MSCI-Emg Mkt -2.93%
 
US Agg Bond 6.79%
US Corp Bond 6.64%
US Gov’t Bond 8.04%

Commodity Prices:

Gold 1,892
Silver 23.37
Oil (WTI) 39.88

Currencies:

Dollar / Euro 1.17
Dollar / Pound 1.28
Yen / Dollar 105.60
Dollar / Canadian 0.74

Don’t miss our in depth review of fixed-income credit spreads pages 2-5!

Macro Overview

The aftermath of Hurricanes Harvey, Irma, and Maria are expected to have uncertain affects on government data and continued ambiguity on economic activity. The hurricanes will distort economic reports quite possibly for months, as labor and material costs weigh on employment and inflation numbers, clouding actual economic results.

Despite major disruptions caused by the storms, equity markets managed to post gains in September as the prospect of rebuilding efforts fueled growth estimates across various industry sectors.

Tax reform proposals spurred discussion and anticipation about their impact on the economy and the markets. Among the plan’s primary particulars are: reduce the number of tax brackets from seven to three, double the standard deduction amount, eliminate state and local tax deductions, tax “pass through businesses” at a 25% rate, eliminate the estate tax and the alternative minimum tax (AMT).

From the perspective of the equity markets, the tax proposals include a generous cut in the corporate rate from 35% to 20%. The corporate tax proposals also include a penalty for companies taking advantage of foreign tax havens, where U.S. companies earning profits overseas will have to pay a minimum 10% tax on foreign income even if it isn’t brought home.

Since the tax plan is still only based on proposals, not an actual bill, market reaction to the proposals may change as to what actual details may pass and are eventually enacted. Economists believe that the Federal Reserve will continue to find it difficult to normalize monetary policy until an appropriate fiscal policy is in place.

The most recent median household income data revealed a 3.2% rise over the past year, net of inflation, according to the U.S. Census Bureau. The larger than expected increase helped stoke support for a Fed rate hike later in the year. Overall indicators of inflation are mixed, with rent and gasoline accounting for the primary rise in inflation while grocery costs and service related fees fell

Puerto Rico, which earlier this year filed the largest bankruptcy in U.S. municipal history, is struggling to regain economic stability in the face of a $72 billion debt load and near insolvent public health and pension systems. Eleven days after the devastating storm wiped out power, water and communications systems, about half of the 3.4 million people on the island did not have access to drinking water, and 95 percent remained without power, according to the U.S. Defense Department   Sources: U.S. Treasury, WhiteHouse.gov, FTC, U.S. Defense Dept., myFlorida.com

 
Fixed-Income Update/Credit Spread Review

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.

 

Continued on next page.

 

 

 

 
Credit Spread Review

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.

 

Continued on next page

 

 
Credit Spread Review

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 Reduction Strategies

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.

 

 

What The FTC Is Suggesting On The Equifax Breach – Financial Planning

As additional government agencies have become involved in the Equifax breach, there have been a growing number of suggested actions for consumers to take in order to better protect themselves. The Federal Trade Commission (FTC) released various action items and links on their website consumer.ftc.gov to help consumers assess their vulnerability.

The FTC acknowledges that there were 143 million consumers affected, with the breach occurring between mid-May and July end. Social Security numbers, birthdates, addresses, and some driver’s license numbers were stolen.

Equifax is offering a free credit monitoring service available at www.equifaxsecurity2017.com. However, this service only applies to credit reports and data maintained by Equifax. Remember that there are two other major credit reporting companies that have consumer data, Experian and TransUnion. The FTC does suggest that consumers check all three credit reports for free via www.annualcreditreport.com. Keep in mind that this free service generates reports that do not include credit scores.

To determine if you are one of the 143 million affected, the Equifax website noted above allows you to enter your last name and last six digits of your Social Security number to determine if your data was compromised. There is a button labeled “potential impact” or “am I protected” which allows you to enter this information.

Placing a freeze on your credit files is a consideration, which makes it more difficult for someone to open a new account in your name. It may also elongate the application process should you be running credit yourself for a legitimate reason. If you decide against a credit freeze, consider placing a fraud alert on your credit files. A fraud alert warns creditors that you may be a victim of identity theft and that they should closely verify anyone seeking credit in your name. The FTC also suggests to monitor your existing credit card and bank accounts closely for charges that are not recognizable.

As we approach year end and a new tax filing season, the FTC is suggesting to file tax returns early. Filing a tax return earlier might avert a tax scammer from using your social security number to get a tax refund based on your information.

Source: Federal Trade Commission; consumer.ftc.gov; The Equifax Breach: What To Do