The global search for yield has driven tremendous fund flows into all corners of the fixed income market. While our primary focus is on investment grade bonds, this trend has also driven yields lower on non-investment grade bonds which are sometimes referred to as “high-yield” or “junk” bonds.
Last week, Third Avenue Management announced that they were freezing withdrawals from a leveraged credit fund. This announcement sent a wave of fear of broader contagion through the high-yield bond market. This fund bought bonds that were both illiquid and very risky from a credit quality perspective. Also, the fund employed leverage (borrowed money) in an attempt to enhance returns. This fund was swinging for the fences and not for risk adverse investors. This turbulence has bled over into the broader category of below investment grade bonds also referred to as high-yield.
Bonds that are below investment grade are often referred to as junk bonds due to the lower credit quality of the issuing companies. Junk bond is a somewhat of a pejorative description of an important part of the bond market. Small companies that are growing, a large engine for the U.S. economy, often fit into the category of below investment grade credit. It is important that there are public market debt financing options available for these entities. Because of the lower credit quality, investors demand more compensation in the form of interest in order to loan these companies money. Due to the lower credit quality there is a higher potential default risk for these bonds.
The genesis of this recent sell-off in the high-yield bond market has been the decline in the price of oil. Many smaller oil and gas companies use the high-yield debt market to finance their operations. When the price of oil declines these small oil and gas companies make less money and have more difficulty paying back the money they have borrowed. As a result, the prices on high-yield bonds in that segment of the market declined. Retail investors in mutual funds became nervous, withdrawing money from high-yield mutual funds and, to meet redemptions, the fund managers had to sell what they could to meet the investor demand for money. This dynamic has caused other parts of the high-yield bond market to decline as well.
Another wrinkle to this negative situation has been the decline in liquidity in the bond market. The Dodd-Frank Wall Street Reform and Consumer Protection Act that came from the financial crisis with the intention of reforming Wall Street has helped to create this predicament. Dodd-Frank severely limits the ability of large bank bond trading departments to inventory bonds, making building an effective market difficult due to capital requirements.
The higher quality investment grade market is where we invest our clients’ fixed income assets. Thus far, the investment grade bond market has only been modestly impacted by the sell-off. By comparison, the Barclays High Yield Index has declined 4.7 percent this year versus the Barclays Investment Grade Intermediate Credit Index which has returned 1 percent.
Our Takeaways from the Week
- We don’t believe that the current disruption in the high-yield bond market will cause a broader contagion in the financial markets
- We are particularly keeping a close eye on investment grade bonds where we have seen only a minor impact
- This week the Federal Reserve hiked rates for the first time in nine years and we continue to expect a slow and gradual rise in the Fed funds rate and interest rates in general
- We believe that this interest rate increase cycle will not end the bull market or push the economy into recession
The bond market is a dealer market with no central exchange. This means that all bond trades are over-the-counter trades whereby market participants trade amongst themselves. By contrast, stocks are traded in a continuous auction market where an investor can get the market price of a stock instantly by seeing where it is trading on the various electronic and physical exchanges. Bond pricing can be more esoteric, particularly for more exotic securities such as some mortgage-backed bonds or high-yield bonds.
The 2008 financial crisis was sparked by speculative mortgage-backed securities which started to fail when homeowners stopped paying their mortgages. Part of the issue was the fact that it was difficult to nearly impossible to value these securities and there was no liquidity for these bonds. The government often regulates in response to the last crisis and this situation is an example of backward looking regulation. As part of the reactive financial market regulation that came out of the financial crisis was that banks are now required to have greater regulatory capital. On the surface this seems like a good idea: banks are required to hold more "safe" assets on their balance sheets like U.S. Treasury bonds to cushion for inevitable bumps in the road. The unintended consequence of this change has made it difficult for large banks to effectively trade fixed income securities. It used to be good business for Wall Street banks to trade bonds with customers. Banks would make a market in bonds and would use their balance sheet to provide liquidity to customers. With onerous capital requirements this business has become difficult and unprofitable for participants. The bond market has gotten much bigger since the financial crisis and much less liquid.
According to the Wall Street Journal, since the 2008 financial crisis the U.S. Corporate bond market has doubled in size to $4.5 trillion dollars. In addition, outstanding U.S. Treasury Bonds trading volumes have fallen 10 percent since 2005 while the size of the market has tripled.
The implication for this change is volatility in the bond market will probably be higher going forward. We have yet to have a real test of bond market liquidity since financial crisis. When interest rates start to climb we will see how resilient the market is when short-term investors in bonds all try to squeeze out the same small door at the same time.
The good news for Ferguson Wellman clients is we largely use individual bonds for clients. This is important because an investor that owns an individual bond can wait out the pricing volatility because at maturity you will get your money back. Participating in panic selling into a volatile or potentially illiquid market is completely voluntary. In the past, we have been able to be opportunistic buyers of bonds sold into illiquid markets. One case in point was the mini-crisis in the municipal bond market when an analyst named Meredith Whitney unwisely used her fifteen minutes of fame on the television program 60 Minutes to incorrectly predict massive defaults in the municipal bond market.
Another silver lining to this potential situation is an advance in technology that could improve liquidity in the fixed income markets. The leading edge of fixed income trading is an electronic bond trading platform that has the potential to revolutionize bond trading. Rather than use a bond dealer intermediary to trade bonds, this platform allows firms like Ferguson Wellman to trade directly with other investment management firms. This concept is in its infancy and Ferguson Wellman is adopting this technology where it can benefit our clients’ portfolios. We are optimistic that wide adoption of this technology can benefit all fixed income investors.
Our Takeaway for the Week
- A lack of liquidity in the bond market may cause volatility in bond prices to be elevated in the future. Owning individual bonds can allow an investor to ride out any potential storms. Also, we think that an eventual broader adoption of electronic bond trading technology will eventually make markets function more smoothly.
Recent weakness in the S&P 500 has led to a lot of chatter regarding the inevitable pullback in equities. While the last few weeks have exhibited some weakness, stocks are still up close to 5 percent, year-to-date. While the United States continues to show improving growth, as seen in recent jobless claims and the Purchasing Managers Index (PMI), global political affairs have wound the markets tight. Russia continues to make noise in the Ukraine while the Middle East is demonstrating that nothing has (nor will) changed for decades. This uncertainty coupled with growth concerns in both China and Europe has led to a rally in bonds as well as a minor sell-off in equities.
The 10-year Treasury now yields just above 2.4 percent, which is the lowest in over a year, as global investors flock to the U.S. dollar and park cash in “risk free” assets. This flow of funds has resulted in weakness in equities. U.S. equities are down close to 4 percent from recent highs which have led to some talking heads focusing on an impending sell-off. However, these 2 to 5 percent pullbacks are normal in bull markets. For instance, over the last 30 months, we have seen nine 2+ percent pullbacks, but the S&P 500 is up over 60 percent in that period. What we continue to watch is improvement in the U.S. economy, growing corporate revenues and reasonable valuation. The current environment is favorable for all of those.
Messin’ with a Hurricane
This week brought the first hurricane to the Hawaiian Islands in 22 years, as well as a “storm of headlines” regarding U.S. companies relocating offshore. The equity market was not too happy with Walgreens’ decision earlier this week not to seek a “tax inversion” with its pending acquisition of Alliance Boots in Switzerland. While domiciling in Switzerland would have saved Walgreens billions of dollars in tax expenses, the company decided stay committed to the state of Illinois. There is speculation that the Obama administration’s use of the bully pulpit was a key factor in management’s decision to continue to pay higher taxes. We believe that an inversion would be more difficult for Walgreens to pull off since most of their revenues are generated in the U.S., thus no offshore cash to repatriate. On the other hand, companies like Abbvie and Medtronic have meaningful amounts of international business, thus their “inversion” acquisitions (Shire and Covidian, respectively) would be easier to justify.
What this recent trend highlights is the need to restructure the U.S. tax code so companies can be more competitive globally. While many of these deals may still be pursued, the tax savings is a key attribute in the overall structure. What can’t get lost in the noise is that although U.S. companies may change their mailing address, they will still bring their offshore cash back to the U.S. and reinvest domestically. With a mid-term election this year, major tax reform may not happen at least until 2015, and possibly not until after the 2016 presidential election.
Too High to Fly
A few weeks ago, the state of Washington started selling recreational marijuana which coincided with the cracking of the high-yield bubble. High-yield bonds have been a strong performer over the last several years; however, like stocks, the month of July hasn’t been friendly to the high-yield market. Spreads have started to increase in the face of lower Treasury yields. This culminated with over $7 billion exiting high-yield funds last week. We don’t believe this is a “canary in the coal mine” with respect to corporate America; however, we are watching it closely. High-yield bonds are trading at historically tight levels, just over 3 percent above Treasury yields, as investors seek income. The long-term average spread has been close to 6 percent higher than Treasuries. Therefore, we would not be surprised if that market continues to show poor performance as we revert back to the mean. While, there are times we may venture into lower rated bonds, we believe that the market as a whole is a bit rich and would wait for spreads to widen further before we allocate additional capital.
Our Takeaways for the Week
- Minor equity pullbacks are common and investors need to stay focuses on the fundamentals
- While July saw a “risk-off” market, we still believe equities will outperform bonds for the rest of 2014