Fixed Income: Fewer Places To Hide

by: Bard Luippold, CFA

In my October 2012 article, "There Be Dragons: Navigating Bond Allocation Through Seas Of Rising Interest Rates," I argued in part that spread tightening in credit asset classes like corporate bonds, municipals and mortgages could cushion the blow of future rising treasury yields, pointing out municipal bonds and corporate bonds, both high yield and investment grade, as having the most potential to tighten.

Since then, as the 10-year Treasury yield has risen from 1.64% on September 26th, 2012, to 2.03% on March 12th, 2013, spreads have by-and-large done just that, tightening and cushioning the blow of rising yields. The chart below shows the performance of the iShares Barclays 7-10 Year Treasury Bond ETF (NYSEARCA:IEF), as well as various iShares bond sector ETFs, since September 26th, 2012.

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While every ETF other than the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG) experienced a negative total return over the period, all of the spread sectors outperformed Treasuries, with municipal bonds and investment-grade corporate bonds the next best performers (see chart below).

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But spread tightening may have now left fixed income investors with fewer places to hide from rising interest rates. This article analyzes the relative value of various spread asset classes versus Treasuries, presenting spread charts and a snapshot of how several prominent fixed income managers are positioning for the current environment.


Let's first take a look at the potential reward for bearing interest rate, or "duration," risk, through owning longer-term U.S. Treasury securities.

Ten-year Treasury note yields have risen nearly 50 basis points since October - a substantial move - but are still bouncing along the bottom of a thirty-year declining channel (see chart below).

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Similarly, while real 10-year yields (e.g. yields minus inflation expectations), have come up slightly since October, they are still close to multi-decade lows, both using survey-based and market-based inflation expectations (see chart below). Indeed, it would take an increase in 10-year yields to 3.3% - or a similar decrease in inflation expectations - just to bring real rates back to 0%.

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In short, while deflationary shocks to the economy and/or stock prices could send 10-year Treasury yields lower in the short term, pure long Treasury exposure does not seem well rewarded over a five-year investment horizon.

However, there is still value in the interest rate curve between 2-yr yields and 10-yr yields. The 10yr-2yr spread was 176 basis points, or 0.91 standard deviations above average, on March 12th, up 38 basis points from September 26th (138 bps; 0.51 standard deviations above average).

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One way to position for the eventual flattening of the steep yield curve - either through further declines in the 10-yr rate relative to the 2-yr or the eventual normalization of interest rate policy - is to own the iPath US Treasury Flattener ETN (NASDAQ:FLAT), which appreciates by $0.10 for every 1 basis point (0.01%) decrease in the 2yr/10yr spread and charges a 0.75% expense ratio.

TIPS - Moving on from Treasuries and pure duration risk, Treasury Inflation Protected Securities ("TIPS") also appear fairly/richly priced. The total return of an investment in TIPS includes both a yield and an adjustment to the principal to account for inflation (click here for more information). For this reason, the yield spread to Treasuries of similar maturity can be negative, as it is now. However, the current spread is much lower than average.

As of March 12th, 2013, the spread between the 10-year TIPS yield and the 10-year Treasury note yield was -255 basis points, down from -241 basis points in September 2012. The 10-year TIPS spread is currently 0.81 standard deviations below average, making TIPS currently look somewhat richly valued (see chart).

Another way to look at the spread between TIPS yields and the corresponding Treasury note or bond yields is through a calculation called "expected inflation" [Expected Inflation = (1+Treasury Yield)/(1+TIPS Yield) - 1]. The basis intuition is that the percentage by which the TIPS yield is below the Treasury yield provides a market expectation of the future inflation adjustment for the TIPS principal. Basically, decreases in the TIPS yield relative to treasuries show up as an increase in expected inflation and increases in yields relative to Treasury yields show up as a decrease in expected inflation.

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However, the spread between Treasury yields and TIPS yield - and by extension, the "expected inflation" calculation - captures both inflation expectations and a yield premium because TIPS are less liquid than regular treasuries. In this way, they are somewhat like credit products, which include a default premium and a liquidity premium - as well as other potential risk premiums - in their yield spread to Treasuries.

During the 2008-09 credit crisis, expected returns in TIPS were driven to historically high levels due to a huge jump in the liquidity premium and a drop in inflation expectations (e.g. as inflation expectations drop, the TIPS yield will rise relative to the Treasury yield). Big declines in inflation expectations also occurred in 2010 and 2011, leading to relatively attractive entry points for TIPS.

However, as noted above, with expected inflation back to recent highs (e.g. spreads to treasuries close to recent lows), TIPS seem somewhat richly valued at these levels, with the main value in the potential for future unexpected inflation. I don't discount this possibility - indeed, I argued for it in "There Be Dragons" and "Who's Afraid of the Big, Bad QE?" - but I think that they represent less of a screaming buy at these levels.

Investors who disagree can gain U.S. TIPS exposure through the iShares Barclays TIPS Bond (NYSEARCA:TIP), which has a yield of 2.23%, a duration of 7.99 years, and charges an expense ratio of 0.20%.

Mortgages: As I wrote in "There Be Dragons," while the Federal Reserve does not publish yields on the various types of residential mortgage-backed securities available to investors (e.g. Agency MBS Pass-Throughs, Agency MBS CMOs, Non-Agency Residential MBS, etc.), they do publish weekly data on the average 30-year fixed mortgage rate, giving a view on the credit spread demanded by the market for making a fixed rate mortgage loan.

Since September, the mortgage spread has tightened from 174 basis points to 152 basis points, partially on the back of the Federal Reserve's $40 billion of monthly mortgage-backed security purchases. Indeed, after starting the period at roughly the average spread level, spreads are now 0.63 standard deviations below average.

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Large-scale Federal Reserve purchases of mortgage-backed securities each month could certainly drive mortgage spreads lower, as they did in 2009 and 2011. Investors who want to position for this eventuality could use the iShares Barclays MBS Bond ETF (NYSEARCA:MBB), which yields 1.64%, has a duration of 3.04 years and charges a 0.26% expense ratio.

However, with spreads near recent tights, I believe that the longer-term case for MBS at these spreads is relatively weak. Indeed, mortgage-backed securities have the unwelcome characteristic of seeing durations rise as interest-rates rise due to lower incidence of refinancing - so-called "extension risk" - which may have been on display over the last six months, as MBB's duration rose from 1.59 years to 3.04 years while its yield fell from 2.59% to 1.64%.

Municipals: While municipal bond spreads continue to look particularly wide to Treasuries, they have tightened from 124 bps to 109 bps (1.23 standard deviations above average) since September (see chart below).

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Potentially clouding the picture is the fact that municipal bond yields have risen steadily compared to Treasury yields since the early 1980s. When we adjust for this by dividing the current spread by the 5-year average spread (e.g. "detrending"), munis start to look more fairly valued, with the detrended spread only 0.50 standard deviations above average (see chart below).

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While I don't think the fears of widespread municipal defaults are likely - see the following article the Schwab for an excellent perspective on muni risks - I don't see as much value in munis at these spreads. With munis the second best performing spread asset class versus Treasuries over the past six months, investors may consider taking some profits at these levels. Investors who believe that muni spreads can tighten further can gain broad exposure to the municipal bond market through the iShares National AMT-Free Muni Bond ETF (NYSEARCA:MUB), which yields 2.83%, has a duration of 6.09 years, and charges an expense ratio of 0.25%.

Corporate Bonds: Over the past six months, Aaa-rated corporate bond spreads - the highest rung of investment grade, equivalent to S&P's "AAA" rating - have actually widened out slightly while Baa-rated (equivalent to the "BBB" rating) spreads tightened.

The Aaa spread widened from 169 bps on September 26th to 195 bps as of March 12th, or 1.33 standard deviations above average (see chart).

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By contrast, the Baa spread tightened from 303 bps to 287 bps, 0.75 standard deviations above average.

This caused the spread between Baa and Aaa bond yields - the so-called "Default Premium" - to shrink from 134 bps on September 26th to 92 bps, or 0.10 standard deviations below average.

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The outperformance of lower-rated investment grade bonds versus higher rated is indicative of investors' continuing "quest for yield" in a zero-interest rate policy (ZIRP) environment. Indeed, average credit quality on the iShares iBoxx Investment Grade Corporate Bond ETF (NYSEARCA:LQD) moved down one full rung over the five month period from A to Baa. Also, moving further down the credit spectrum, the iShares iBoxx High Yield Bond ETF was the best performing U.S. credit iShares ETF over the past six months, outperforming 7-10 year Treasuries by over 6.5% as high-yield bond yields sank to record lows.

The recent outperformance in the high-yield asset class - and the fact that high-yield bond yields are at record lows (see chart below from Morgan Stanley, by way of Business Insider), has spurred a debate as to whether a dangerous bubble is growing in the market.

Zero Hedge has taken the "pro" bubble side, arguing that covenant protections are at an all-time low and the cash-to-debt ratio is sinking rapidly for high-yield issuers, while Business Insider recently published a "con-bubble" article which retorted that high-yield spreads are still reasonable, firms are being less aggressive with bond-issuance proceeds and the cash-to-debt ratio is still relatively high.

Anecdotally, competition in one corner of the high-yield finance market - sub-prime auto loans - has been heating up to pre-crisis intensity recently amid an environment of abundant capital and easier credit underwriting standards. In a recent earnings conference call, the Treasurer of a major sub-prime auto lender said: "... We have historically found that the primary factor that impacts how competitive the environment is, is the availability of capital in the industry. At the current time, capital is readily available. And due to the low interest rate environment, capital is very cheap. That has led to an increase in competition. We're responding in much the same way that we did in 2006 and 2007, which was the last competitive period in our industry." These comparisons of the current environment to the pre-crisis credit boom period give pause.

Even if a high-yield crash does not materialize, the fact remains that higher-grade bonds seem to be a better relative value at these levels, with Aaa yield spreads still 1.33 standard deviations above normal.

Investors can gain exposure to higher rated corporate bonds through LQD, which has an average credit quality of Baa, yields 3.84%, a duration of 7.75 years and an expense ratio of 0.15%. Other options include the iShares Aaa - A Rated Corporate Bond EFT (NYSEARCA:QLTA) - which has a higher average credit quality (A), a yield of 2.12%, duration of 6.48 years, and a 0.15% expense ratio - and the iShares Barclays 1-3 Year Credit Bond ETF (NYSEARCA:CSJ). CSJ has a 1.54% yield, average credit quality of Baa, and a 0.20% expense ratio.

How Have Fixed Income Managers Been Positioning? To see how several large fixed income managers are responding to the current environment, the following table uses data from Morningstar to compare the most recent reported portfolios of four large intermediate bond funds - PIMCO Total Return, Metropolitan West Total Return, DoubleLine Total Return and Dodge & Cox Income - with the Vanguard Total Bond Market index ETF (NYSEARCA:BND).

As they were in September, all of the managers are heavily underweight U.S. Treasury securities and have lower duration (e.g. lower interest rate risk) relative to their benchmark. However, the sectors they choose to overweight, and the changes some of them have made in these sectors since September, are striking.

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PIMCO's Bill Gross maintained his focus on securitized products and away from U.S. Treasury securities. However, within securitized products, he shifted dramatically away from more esoteric securities, like Collateralized Mortgage Obligations ("CMOs"), Non-Agency Residential Mortgage Backed Securities ("RMBS") and Asset-Backed Securities ("ABS"), in favor of more plain-vanilla, Agency MBS Pass-Through securities. DoubleLine's Jeff Gundlach and the Dodge & Cox Income team were also overweight Agency MBS Pass-Through, suggesting that they see value in the argument of further mortgage spread tightening due to Fed asset purchases. Interestingly, Gross also changed his allocation within the Government securities category to heavily overweight non-U.S. Government securities, slightly increased his allocation to TIPS and decreased his allocation to municipal bonds by more than half.

DoubleLine and the Metropolitan West team both maintained their strong focus on securitized products, with Metropolitan West focusing on ABS and Non-Agency RMBS and DoubleLine focusing more on Collateralized Mortgage Obligations ("CMOs") and Non-Agency RMBS.

Dodge & Cox maintained their strong focus on corporate bonds - which makes sense, given their unique discipline of having their equity analysts rate both the equity and the credit of companies they cover - but actually reduced their corporate bond holdings and increased both cash and U.S. Treasury allocations over the period.

Finally, and interestingly, all of the managers studied actually increased their allocation to U.S. Treasury securities over the period, while maintaining strong underweights versus their benchmark.


The table below shows the evolution of yields and spreads for various fixed income asset classes over the past 5 1/2 months. The implication is that, while TIPS, mortgage backed securities, municipal bonds and high yield bonds have worked well for fixed income investors over the recent past, there may now be fewer places to hide from a rising interest rate environment.

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Indeed, back in September, there were three sector spreads (counting detrended munis and no the actual muni spread) which were above 0.80 standard deviations above average. Now, there is only one. Aaa corporate bonds and the 10yr - 2yr Treasury spread seem to represent the best values when spreads are compared to average historical spreads, while detrended muni spreads and the lower rungs of the investment grade corporate space have room to tighten down to an average spread as well.

Of the group, TIPS, followed by mortgages, seem the most richly valued, though the managers profiled in the table above seem to be comfortable for the moment with the case that current monetary policy will result in unexpected inflation (e.g. TIPS) and continued spread tightening in mortgages.

In general, managers continued to position for this environment by keeping interest rate risk low and allocating away from U.S. Treasury securities in favor of sectors that can offer some spread compression to cushion the blow of rising interest rates.

Disclaimer: Bard Luippold, CFA, is Corporate Finance Manager for Meracord LLC ("Meracord"). This article is prepared by Mr. Luippold as an outside business activity. As such, Meracord does not review or approve materials presented herein. The opinions and any recommendations expressed in this article are those of the author and do not reflect the opinions or recommendations of Meracord.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.