- 2009 was a banner year for the credit markets – even record setting in some areas.
- A future tightening bias from the Fed does not automatically translate into a down year for fixed income.
- My expectations for 2010: another good year, but with moderating returns.
For the credit markets, 2009 will rank among the best ever in terms of total return performance. Leading the way with its own best performance ever is the High Yield sector. The primary index we follow (Barclays Capital High Yield) returned 58.2% in 2009. The prior best for this index was a 46.1% return in 1991. The riskier, lower rated component of this index (“Caa” rated) returned an outstanding 90.6% - also a record, and its best since a 46% return also occurring in 1991. The investment grade Credit Index returned 16.0% marking its best year since a 22.2% return in 1995. The dollar denominated Emerging Market Debt index returned 34.2% - its best performance since a 38.8% return in its inception year in 1993.
Clearly, the themes of 2009 were the return of risk appetites and the search for yield among fixed income investors, something that I have written about in past commentaries.
The Municipal Bond index returned 12.9% last year - the best performance for that index since returning 17.4% in 1995. For all the negative news about the dire fiscal predicament of state and municipal governments, it had little impact on the muni market as a whole last year. There have been ratings downgrades and a few bond defaults, but no widespread disaster from the tax-backed and essential purpose / utility issuers in the municipal bond market.
There were several different themes that played out in the municipal bond market in 2009. The further demise of bond insurance is one of them. Not long ago more than half of all bonds coming to market carried some kind of insurance wrapper, giving them a higher rating and an interest cost savings as a result. Today the field of viable insurers has been narrowed to two and only one of them is actively pursuing new business. We used to have an old saying: “if it qualifies for bond insurance, then you probably don’t need it”. It may not be that simple today, but if you stick with issuers that have a more dependable stream of revenues to support debt service, then you should be able to avoid many of the problems in the muni market.
Another theme was the painfully low rates from municipal money market funds. It just did not pay, literally, to be in cash. This no doubt had an impact on flows into municipal bond mutual funds in 2009. It was a record year as fund flows averaged $1.5 billion per week to a total of $78 billion-plus in 2009.
TIPS: Treasury Inflation Protected Securities had a great year of performance too. Unlike nominal Treasuries (more on them below) TIPS benefited from the expectation of elevated levels of inflation. The TIPS index’s return (Barclays Capital TIPS Index) of 11.4% was impressive, certainly compared to regular Treasuries. But it should be noted that TIPS shaved 219 basis points of return off the top during the final month of the year. As I have pointed out in the past, at any given narrow time period, inflation-linked bonds can move in lock-step with any other long duration instrument. This is what happened in December when long-term rates on conventional Treasuries really began to rise. TIPS offer a buffer against inflation expectations, not against interest rates that rise for other reasons.
There was one asset class that did not perform well in ’09 and that was the Treasury market, which was the safe haven and preferred asset class of 2008. Treasury bond investors were reminded that this “riskless” asset class is not without – risk! They may be issued and guaranteed by the United States government (thus eliminating credit risk), but they sure do carry market risk. The Treasury Index saw a reversal of fortune in 2009 and lost 3.5%. This marks the first down year for this index since a 2.5% loss in 1999. Interestingly, this was only the third annual loss for the Treasury index since its inception in 1973.
Speaking of Treasuries, there has been a lot of coverage lately about the steepness of the yield curve. You can measure it in a variety of ways, but the final outcome will give you the same message. The spread or difference between short-term Treasury rates and longer-term rates is significant by historical measures.
Right now the curve is steep and getting steeper. Why? Part of the reason is the Fed Funds rate being at or near 0.00%, which is keeping short-term rates artificially low. Factor in the weak Treasury market (the long end sold off in December and added between 44 and 69 basis points of yield depending where on the curve you look) and that adds to the spread differential between short and long rates. The Treasury market is selling off because 1): economic data are continuing to come in strong and this should further advance the recovery. A growing economy diminishes the demand for Treasury bonds. 2): Anyone worried about the Treasury Department flooding the market? Apparently some investors are after seeing estimates that government borrowing will exceed $1 trillion in 2010, just like it did in 2009. That is a lot of bonds for the market to absorb.
Even though the Fed and Chairman Bernanke may be on hold and not currently raising the Fed Funds rate, in effect, the market (meaning investors) is doing the work of the Fed by raising longer term rates through selling / not buying. Our chart below illustrates where interest rates have changed over the past year. You can clearly see that there is very little movement on the short end while yields on longer maturities have risen significantly.
When Treasuries do sell off, it does not mean that credit sectors are going to do the same. As I stated above, it has been a down year for Treasury investors (Treasury index is down ~ 3.5%), but many other areas of the market that we discussed above are up rather nicely.
I'm sure we will be seeing a lot of articles about the effects of rising interest rates when the Fed eventually does begin to raise rates. The last time the FOMC raised rates for an extended period was between 6/30/04 and 6/30/2006. There were 17 consecutive tightenings (rate hikes) of 25 basis points and the Fed Funds rate went from 1.00% to 5.25%. In anticipation, I prepared a brief review of some fixed income indices and how they performed during the last period of rate hikes. Their returns are in the box below.
Many factors could alter the outcome of future interest rate hikes such as the length of time in the rate hike cycle and the extent of the increases. The point I am trying to make though, is that a rising rate environment does not necessarily result in a period of negative returns.
Treasuries: They ended 2009 a lot cheaper than where they began the year. For investors going into 2010 with a highest quality only mandate this is good news. There is more value in the intermediate to long end due to recent pricing pressures from large supply, inflation concerns and a brightening economic outlook. If the Fed acts sooner, then we could see some of the steepness removed from the curve as short rates are taken up in yield. It is possible for short end rates to increase and only see modest corresponding move on the long end. Interest rate increases from the Fed typically have a greater impact on the short end while market forces dictate what happens on longer maturities.
TIPS: We still like and continue to have exposure to them. We like them for their high quality and inflation-hedging characteristics. Inflation is not a problem today, but the time to buy insurance is before you actually need it. If you want higher quality exposure, favor TIPS over nominal Treasury bonds.
High Yield Credit: I expect a continuation of positive performance from speculative grade credit, but I do not see how we can rationally expect a repeat of the stellar returns seen last year. It was hard to go wrong with the high yield asset class in ’09. I suspect that 2010’s fixed income mutual fund returns will be more research driven from portfolio management teams as research will be a more important driver of returns than just indexing. Another reason to remain positive is because the companies in this asset class historically do better in better economic times. The ones that survived the past couple of years come out stronger and the headwinds become tailwinds for them as the economy improves.
Credit: Investment grade credit should do okay, too. There is less room for tightening of spreads, but there is still room overall. There is more to total return than price appreciation alone and larger coupon bonds will provide current income that should keep them in positive territory.
Municipal bonds: I expect this asset class to remain popular among tax-sensitive investors and this should keep munis well bid and in demand. Additionally, reduced supply as a result of the popular Build America Bond program (taxable munis where the issuers receive a Federal subsidy) should help too. This in turn ought to help returns in 2010, but once again I don’t see the performance of 2009 being repeated.
I do not expect to see widespread defaults (I touched on this earlier) as municipalities and other municipal issuers make the hard choices between raising taxes / revenues and cutting spending. According to the Center on Budget and Policy Priorities, at least 30 states have raised taxes while 43 states have reduced spending on services. This may be tough medicine for those of us who either pay taxes or consume them by using the services that states provide, but it is necessary.
States will be in the news with their budget woes (California, for example) saying they need assistance or face drastic cuts in services. They don’t have a revenue problem, they have a spending problem and elected officials need to do their job and find the right remedy to balance budgets. The problem, of course, is to find the ones who are willing to compromise.
Taxes: Earlier this year I stated my expectations for income tax increases at some point in the future at both the State and Federal level. This was not exactly going out on limb because there are a few items that point toward higher taxes. As I noted above, many states raised taxes and fees in ‘09. At the Federal level I still expect income tax increases are on the way. For one thing, the tax cuts enacted by President Bush have a sunset provision (2010) and unless Congress acts to extend or make them permanent, then tax rates will go to their previous levels. Think about it – all Congress has to do is nothing and rates go higher. What an easy way to raise taxes without actually voting to raise taxes!
The next big item pointing toward higher taxes is the Federal budget deficit. Over the years the government has this tendency of raising tax rates when faced with big spending programs. The various forms of stimulus spending on projects and health care reform constitute big spending and they need to be paid for. This is not intended to be a political comment, just a fact.
Our best advice is this: Balanced and diversified portfolios historically offer a level of protection from volatility and offer solid risk-adjusted returns. I am not just talking about stock, bonds, alternatives and cash here. Investors should also diversify within asset classes themselves. Fixed Income allocations should hold some high quality items (Treasury and agency paper), some credit items from different sectors (industrials, utilities, tech…) and structure the maturity schedule so that not everything is short or long, but balanced.
Disclosure: No positions