In our initial Fixed Income Allocation strategy, we were mainly in cash with our long positions in high yield, leveraged loans, financials and some inflation linked products. Since then, we adjusted the mix by at first selling some high yield to buy treasuries. We then moved out of treasuries, added back the high yield we sold and actually bought more. Since then we have scaled back on high yield as the fact that the HY ETFs moved (however briefly) to a discount to NAV is a big warning flag for us.
The three questions we thought were key drivers for the allocation at the time were:
How Strong is the U.S. Economy?
Our base case view is that the recent data (jobs in particular) was overstated because good weather made everything easier (unlike a typical winter) and seasonal adjustments are still skewed from the financial crisis, but the economy is doing okay. So in an okay economy treasuries sell off a bit, but with more QE still on table the sell-off is muted, and credit spreads do well.
Is the next round of the European Debt Crisis already here?
Our base case is that weakness in Spain and then Italy drive another round of fear into the system. Talks will shift from firewalls and austerity to PSI across the board. A realization that debt needs to be cut will take over. Banks will be made to pay for their bad lending decisions and will effectively be charged for their dependence on central bank financing. This will help treasuries more than any other scenario, and will be bad for spread products, though the market is likely to punish European credit spreads far worse than domestic ones, with banks the big losers in Europe. We think the market here will be more resilient as people have seen a separation of the U.S. from Europe's woes.
How will China Land?
This still seems like a coin-flip to me.
Translating the views into allocation
With our base case views we think there will be an opportunity to buy treasuries at much higher yields during this quarter or to buy credit products at a somewhat higher yield. That is our rationale for remaining heavily in cash. We have concerns that inflation is creeping into the system and all the money printing may have started to achieve enough asset price inflation that we get some more hawkish Fed comments in the near term. The opportunity cost of sitting in cash is surprisingly low.
Less in high yield and more in treasuries would have been a good thing. The decision to sell some high yield and allocate into treasuries was good and generated some profit to offset the long in high yield, but we were too quick to take profits and to re-allocate into high yield. Tips are up nicely since the recommendations. Leveraged loans are down a bit, but net of carry close to flat. Financials have widened on a spread basis but have been supported by the move in treasuries.
15% to Leveraged Loans:
There has been no change to the thesis or position.
15% to high-yield bonds:
This got reduced to 10%, taken up to 20%, and remains at 15%. It will go lower with continued problems in Europe and we will look to add more here except in the case that the ETFs in particular go back to trading at a discount to NAV. The "arb" activity could put pressure on the entire market.
5% to U.S. Financials:
We remain comfortable with this allocation. European bank spreads have more direct support from LTRO than sovereign debt, or the equities of those banks. They will widen, but in most cases not as much as last year. In any case, even that spread widening is less likely to impact U.S. financials as the market has realized the U.S. banks have far less exposure to Europe than many thought. Continued weakness on the job and housing fronts would be a cause for concern.
5-10% to TIPS:
I continue to like these, and the corporate or financial CPI bonds offer good value relative to even TIPS.
5% to Emerging Markets:
Local currency bonds are down, foreign currency bonds are up since the start of the month. Had this as 5-10% and for now move back to lower end of the range. A mix of local and foreign still seems the right trade, as scenarios that affect the currency either way are still in play.
5% to down and dirty RMBS/CMBS:
Looking to add to this, but still no easy way as the idea is at the more distressed end of the range, and it is harder to find a could vehicle to play in that space.
45-50% in t-bills:
Continue to stay in t-bills. I hate the idea that many money market funds have been creeping up their allocations to European banks. I'm reasonably comfortable with them, but wouldn't take the risk for a few bps at the short end of the curve.
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