- Actions by central banks and FX reserve managers have materially reduced the supply of investable assets.
- Government bonds and high capitalization stocks continue to benefit from this trend. However, prudent investors may want to put some inflation hedges in place now to protect gains.
- U.S. corporate bonds are much more expensive today than they were back in 2007, even when considering spreads were just as tight as they are now.
Flow Adjusted Float
The difference between the amount or stock of assets outstanding and its tradable flow adjusted float is rarely discussed by research analysts and advisors. The issue is an often overlooked or neglected area of portfolio management. Simply put, the flow adjusted float of an asset class is a better and more representative proxy of the investable universe than the outstanding stock of such an asset. If the difference between the two is large and growing, as is now the case, the investment implications are profound.
Let's look at a highly stylized example in the table below. A global bond index that follows a strict market capitalization rule would allocate money to each country shown below based upon relative weights of total outstanding debt- in this case 28.5% each to the U.S., Japan and the Eurozone and 14.3% to the UK. In comparison, a flow adjusted allocation methodology would have a much higher allocation to the Eurozone a lesser amount dedicated to other countries. It's potentially a huge difference.
Stock of Debt
Now let's take this example to its extreme yet logical conclusion. Assume the U.S. Treasury issued $100 in notes and bonds and for various reasons the Federal Reserve purchased $90. Now although the stock of bonds is $100, the available float is only $10. Most investors would agree that the risk profile of the remaining $10 bond is quite different from the original $100. Obviously the liquidity profile has been significantly altered as well. The biggest concern is that the holder of the $90, in this case the Fed, can control and set the price of the entire issue. The price signal mechanism simply no longer works.
Next let us consider that the difference between the stock and float of available debt is large and growing rapidly. According to Yardeni Research total assets of the world's major central banks is about $14.3 trillion, which is mostly comprised of government, agency and MBS securities. Add to that another estimated $7 trillion (SOURCE: IMF) held by foreign exchange reserve managers and we now have over $20 trillion of assets that have been effectively and near permanently removed from the market. That's ominously more than a single year's worth of U.S GDP! This issue will grow larger if the European Central Bank embarks on a quantitative easing program, which seems increasingly likely.
The issue becomes even larger when you consider new collateral and liquidity requirements imposed upon banks in the wake of the financial crisis. Collateral accounts and liquidity portfolios tend to hold the same type of securities as central banks and reserve managers, namely high-quality bonds. Estimates of this new source of demand vary widely from $800 billion (Bank of England) to $4 trillion (ISDA). Securities held as collateral or in a liquidity portfolio are effectively retired, further diminishing the genuine amount of bonds freely available to trade.
The sizeable divergence between the stock of outstanding debt and flow-adjusted float is not exclusive to the bond markets. Restricted stock, lock up periods and stock held in company pension plans can all meaningfully reduce a stock's free float. The impact can at times be substantial as when the Twitter (NYSE:TWTR) lockup period expired sending their stock prices considerably lower. Central banks and foreign exchange reserve managers seem to be expanding their investment universe and no longer limit their purchases to short dated, highly liquid instruments.
- A large and growing difference between the stock of debt and its flow adjusted float is highly supportive of a secular low yield environment and a flatter yield curve. You can conveniently gain exposure to this trend via iPath UST Flattener ETN (NYSEARCA:FLAT), which is up 8.17% so far this year.
- Bond yields no longer provide robust price signals about the future prospects of inflation. The best inflation hedges remain real assets such as SPDR Gold Shares (GLD), iShares Tips Bond Fund (NYSEARCA:TIP) or iShares Global Timber and Forestry ETF (WOOD), which primarily invests real estate and basic material companies such as Weyerhaeuser (NYSE:WY).
- Low bond yields artificially inflate the price of other cash flow generating assets. An investor should discount an asset's expected cash flow at a rate that reflects the riskiness of those cash flows, not the rate on risk-free assets that are in short supply. More importantly, a shrinking supply of risk-free assets has likely led to increased demand of other assets like stocks and alternative investments.
- Somewhat counterintuitively, lower market interest rates inherently raise the riskiness of companies that sport high debt to equity ratios. Investors should avoid High Yield investments such as iShares iBoxx HY bond Fund (NYSEARCA:HYG) for now.
- There is no reason to suspect any of this will change soon, even considering the Fed's tapering bond purchase plans.
- In our view, the best approach remains to hold a broadly diversified portfolio between stock and bonds with a healthy allocation to inflation hedges.
Non-financial Corporate Debt
It's not too surprising that corporate treasures are busy borrowing money in today's ultra-low rate environment. Non-financial corporate debt is playing an increasingly important role as a substitute for all the risk-free alternatives permanently removed from the market as already discussed. According the Fed's Flow of Fund Data, such debt is now growing at 10% annual pace. Corporate borrowing topped out at 14% growth rate in 2007 right before the onset of the 2008 financial crisis. There are two main differences worth noting between 2007 and now. First, although corporate bonds spreads were as tight in 2007 as they are today, interest rates were much higher. Hence, investors received more compensation per unit of risk than they do today. Lastly, bond mutual funds and ETF holding were a fraction of what they are today. We are all watching to see how this story ends.
The difference between the stock of outstanding assets and its related flow adjusted float is an important distinction that investors need to consider. The large gap between the two is highly supportive for continued low-interest rates, while falsely inflating the value of some cash flow generating assets. However, it also raises the demand for other assets pushing up prices. The rebound in non-financial corporate debt is a welcome sign and should fill the void left by the retirement of many risk-free assets. However, the growth in corporate debt does not come without some disturbing signs of potential trouble ahead.