The financial crisis both triggered and exacerbated numerous changes in the global economy: An accelerating shift in global growth from developed market consumers toward emerging markets; the reversal of a multi-decade credit binge; significant deterioration in sovereign balance sheets; the ballooning of central bank balance sheets; contraction in the financial services industry; and the re-emergence of financial repression as a tool of monetary policy.
Investors are now contending with the implications of these changes, which include slower growth in the developed world, negative real interest rates and the potential for a more volatile inflation environment.
Fixed income investors in particular face a stark choice between low nominal rates-and often negative real rates or increasing risk to generate incremental yield.
In assessing these options, investors must start with their own tolerance for risk and investment objectives. For those investors whose objectives require additional yield, and who are willing to take on incremental risk, there are several choices. Our view would be that investors consider some reallocation toward equities, particularly dividend-paying stocks. That said, given its role as a source of stability and income, fixed income will and should remain a significant portion of most portfolios.
Within fixed income, we would advocate reducing duration risk-for which we believe investors are not being adequately compensated-and modestly increasing exposure to spread products. We would advocate looking to U.S. corporate debt-specifically investment grade-high grade municipals and emerging markets.
Less Than Zero
If you don't like something, change it. If you can't change it, change your attitude.
While the Federal Reserve Board's (Fed's) zero interest rate policy (ZIRP) and various asset purchase programs may be necessary to offset the ongoing consumer de-leveraging, they are also a bane to savers. Over the past year, the slow evaporation of fixed income yield has turned into a vanishing act. At one point earlier this year, the entire U.S. Treasury curve-up to and including the 30-year bond-was yielding below the rate of inflation. Unfortunately, there is nothing that investors can do to change this. Following Ms. Angelou's advice, a change in attitude in the face of a different investment landscape may be in order.
The change in attitude toward risk, and what risks investors are willing to accept, is an inevitable, perhaps intentional, result of the current policy mix. Short-term paper has effectively been paying zero since late 2008, and going further out on the yield curve offers little benefit.
In framing this issue, it is instructive to take a step back and quantify just how unusual the current environment is. Even after removing the 1970s and early 1980s, a period of unusually high nominal yields, the long-term average yield for the 10-year note is still 5.25%, more than twice today's level (see figure 1).
The yield picture looks even starker when taking into account inflation or inflation expectations. In the past, the yield on the 10-year Treasury has averaged roughly 2.6% more than the inflation rate, roughly in line with what most economic text books would suggest is the "real" interest rate. Interestingly, the real rate in the United States has been stable over the long term, and is relatively invariant to how you calculate it (you get the same 2.5% real yield when you compare the yield on the 10-year Treasury to headline inflation, core inflation or simply use the average yield on 10-year TIPS). Even as recently as last February, real rates, measured using core inflation, were still around 2.50%.
More recently, that long-term stability has broken down. Last year's combination of slowly rising inflation, risk aversion and asset purchases pushed real rates into territory last seen in the early 1980s. As of the end of February, the yield on the 10-year Treasury was 33 basis points (BPS) below the level of core inflation, the widest gap since 1980 (see figure 2). Negative real yields are also evident when looking at the yields on 10-year TIPS, which were at -0.30% as of the end of February.
Some have argued that while low yields are obviously unpalatable to savers, they are justified given the anemic state of the recovery. To the extent the United States is recovering from a credit bubble - an event without any real precedent in the post-World War II period - Treasury bonds may be less overpriced than they appear.
Theoretically, there is some basis to this argument. In a slow growth world, individuals and businesses are less apt to borrow and the cost of money drops. However, while weak growth partly explains why rates are so low, the economy is not so weak as to justify today's negative real yields. With U.S. growth at roughly 1.6% year-over-year and 3% annualized in the fourth quarter of 2011, you would expect real rates of approximately 1% to 2%, not negative (see figure 3). We repeated the exercise looking at consumer confidence. Again, we come to the conclusion that while real rates should be low, fragile confidence does not explain today's rock-bottom levels.
While the current environment is grim, it does not appear grim enough to justify accepting negative real yields. Some bond bulls argue that the United States, as well as large parts of the developed world, is at risk of deflation. A long-term slide from low inflation into deflation would mean that real yields are not as low as they appear, as inflation will fall further in the future. Given the aging of the population and the magnitude of the U.S. de-leveraging, this is not an unreasonable concern.
However, we still believe it's unlikely. U.S. demographics are deteriorating, but they actually appear better than most of the developed world with the U.S. population expanding at close to 1% a year. In addition, the United States is not graying nearly as quickly as the rest of the world. In Japan, the percentage of people over 65 is already at 25%, and the elderly outnumber the young (15 years or younger) by more than 2 to 1. In contrast, in the United States the proportion of the population over 65 is barely 14%, and those under 15 still outnumber those over 65 by 1.4 to 1.
It is also important to recognize that the U.S. monetary response to the financial crisis was both quicker and bolder than that of the Bank of Japan (BOJ), which waited several years after inflation turned negative before starting to aggressively expand its balance sheet. In the United States, quantitative easing began in late 2008, when U.S. inflation was still very positive. This is important as deflationary expectations have never taken hold in the United States the way they did in Japan. As a result, inflation in the United States has taken - at least this far - a very different trajectory than in Japan (see figure 4).
We would suggest that for longer-term investors, inflation should be the bigger concern. To be sure, with wage growth non-existent and the U.S. economy still laboring under excessive capacity, inflation does not appear to be an imminent threat. That said, some things have started to change. Although the job market remains moribund, non-farm payrolls are now growing at 1.5% year-over-year. This is faster than the population growth and a level that historically has been associated with modest (3%) inflation a year later.
In addition, investors have thus far taken great comfort in the fact that while the Fed has aggressively expanded its balance sheet, the net effect has been to balloon excessive reserves, not the money supply. While banks were not lending - commercial and industrial loan demand contracted for 23 out of 24 months between late 2008 and late 2010 - this was not a problem.
However, commercial lending is now rising, and money supply growth has been accelerating. In January, M2 was up more than 10% year-over-year, the fastest rate of growth since early 2009. Historically, changes in the money supply have led changes in inflation with a two- to three-year lag, suggesting that inflation is not a 2012 problem. Still, given the magnitude and unprecedented nature of the Fed's unconventional monetary policy, coupled with the fact that bank lending and the money supply are growing again, it seems a bit complacent to expect that inflation will remain well behaved in perpetuity.
When Price is Not an Issue
The real answer to why Treasury yields are so low may lie in the nature of the buyers. All of the discussion so far has attempted to reconcile price - measured by the real yield - with the fundamentals. This assumes that the marginal buyer is motivated by price or expected return. As it turns out, over the past several years, and increasingly last year, the market for longer-dated U.S. Treasuries has been dominated by public, not private, sector buyers.
Investors are all too familiar with the Fed's various asset purchase programs - QE1, QE2 and Operation Twist. Most are also familiar with the role that Treasury securities play in the reserve management of China, Japan and others. What is fascinating is how these two forces have combined to effectively dominate the market for Treasuries with a maturity of five years or more. Since 2008, Federal Reserve and foreign official sector buying has absorbed 70% of the issuance with maturities of at least five years (see Figure 5). In 2011, the trend intensified, with the Federal Reserve and the foreign official sector purchasing 105% of the new supply of long-term Treasuries, leaving private investors as net sellers.
This may be the most important piece of the puzzle. To the extent the Fed extends its asset purchase program and foreign official buyers continue to be insensitive to price, then yields are likely to remain low. However, unless you believe that the Fed's asset purchase programs have become a semi-permanent policy feature, eventually rates are likely to normalize once the Fed begins to adjust its balance sheet.
In addition, it may be a mistake to assume that the foreign official sector's appetite for Treasuries will always remain voracious. In 2011, there was a modest but still significant drop in Chinese demand. For the time being, this has been more than compensated for with a pickup in Japanese buying. However, to the extent China succeeds in rebalancing toward a more consumption-driven economy, all else equal, this would imply a long-term rebalancing toward smaller trade surpluses and an accompanying deceleration of Treasury purchases by China. Either a deceleration in Asian central bank purchases or the lack of a new asset purchase program will risk a backup in yields. Even if this does not occur for a number of years, investors are still left with negative real yields in the interim.
One final point on the attractiveness of the U.S. Treasury market and the rewards of taking duration risk: Today's investor in a long-dated U.S. Treasury is not merely settling for lower returns but also taking on considerably more risk. As coupon payments have collapsed, most of a bond's cash flow comes at maturity. This has the mechanical effect of pushing up the weighted average time until repayment, or duration. Bond holders in a low coupon world are taking on additional risk-even when the maturity of a bond or benchmark remains the same (see figure 6). For example, the JPMorgan Aggregate Bond Index's modified duration has risen from 4.2 in 1990 to a record of nearly 6 today. Even compared with the depths of the financial crisis, the duration of this index has risen by approximately 20%, indicating greater sensitivity to rising rates. As such, even a modest rise in rates will result in greater losses for holders of long-dated Treasuries.
Given the likelihood for negative carry, potential for significant loss in purchasing power, and the additional duration risk, we believe that investors looking for incremental yield should avoid extending their duration, and instead consider spread products.
The Positive Side of Risk Aversion: Credit
One of the contributing factors to last year's bond market rally was a bout of extreme risk aversion that began last spring and lasted for most of the remainder of the year. A small subset of assets - U.S. Treasuries, Bunds, the Swiss franc and gold-benefited; everything else was punished. While this shift away from risk pushed Treasury yields to record lows, it also created a number of opportunities in other asset classes.
Over the past three months, stocks and high yield bonds have been the main beneficiaries of a "risk-on" trade. However, within fixed income other segments of the market have not benefited as much and therefore still appear attractive.
In a previous paper we highlighted some of the opportunities in the municipal market. We still believe that high-quality municipal issues make sense for U.S. taxable investors. Beyond municipals, we see at least two other segments in the fixed income space that offer attractive yield with a reasonable risk/reward balance: U.S. corporate credit - particularly investment grade-and foreign bonds, especially emerging markets.
Starting with U.S. credit, while investors have recently been flocking to high yield - flows into U.S. high yield ETFs were up approximately $6.5 billion during the first three months of the year - we see particularly good relative value in parts of the investment grade spectrum, particularly the lower strata. Figure 7 illustrates the spread between Baa bonds (using the Moody's Baa Index) and the 10-year Treasury. Over the very long term, this segment of the investment grade space has yielded roughly 180 bps over the 10-year Treasury. Looking at more recent history, spreads have been a bit wider, averaging roughly 230 bps over the past two decades.
Today, the spread is approximately 320 bps, about where it has been since last fall. Interestingly, while high yield spreads have contracted by nearly 250 bps, spreads in this segment of the corporate sector have barely changed.
Today, investors have the opportunity to pick up roughly 300 bps over a 10-year Treasury. Not only is this spread high by historical standards, but it is available at a time when government credit quality is deteriorating and corporate balance sheets have rarely looked better. In addition, current spreads in this sector also look wide, not only compared to their history but even after taking the economic environment into account. In the past, spreads have been widest when leading economic indicators are indicating slow growth or an outright recession. While the relationship is not linear - slow growth lifts spreads more than fast growth compresses them - it has been significant. Historically, this relationship with leading indicators has explained roughly 30% of the variation in credit spreads (see figure 8). Based on this relationship, spreads in the Baa sector appear approximately 100 bps too wide.
While we think the Baa segment looks attractive, there is one risk factor investors should be aware of. Arguably the reason spreads are this wide today is that this segment of the investment grade universe is dominated by financial companies. We believe that the financial sector has stabilized, and that the credit risk is acceptable, but investors should be aware that the performance of these issues is tied to the financial sector and financial market stability.
In comparison to investment grade debt, we would not be aggressive in over-weighting high yield, although we still see a place for it. High yield spreads have already compressed, falling from 750 bps over 10-year Treasuries in September to 500 bps by the end of February.
As with investment grade debt, high yield spreads tend to be very sensitive to economic expectations. In the case of high yield, this relationship is even stronger; leading indicators explain more than 50% of the variation in spreads (see figure 9). Based on that relationship, high yield spreads look close to where one would expect, given the current state of the economy. Should the economy accelerate further, then we would expect further tightening. However, should growth remain at or around the 2% level, then we would expect that most of the easy gains in high yield have already occurred.
Just as investors are often too reliant on domestic issues in their equity portfolio, they tend to have the same - if not worse - bias in their fixed income portfolio. Today, there are several arguments favoring more international diversification. In particular, as investors have become more comfortable with emerging market equities, we would suggest that they should also be considering emerging market debt.
In last November's Market Perspectives ("Are Emerging Markets the New Defensives?") we highlighted the growing economic stability in most emerging markets, and the growing instability of much of the developed world. The convergence in macroeconomic volatility is important since macro volatility has historically been the major driver of financial asset volatility. In a world in which emerging markets are less volatile relative to developed ones, this suggests that emerging market stocks and bonds should also be less volatile relative to their developed world equivalents. All else equal, to the extent that emerging market relative volatility is falling, this asset class should command a higher allocation in a portfolio.
Part of the rationale for emerging markets' new-found stability is that emerging markets exited the financial crisis in a far better position than their developed market counterparts. In the space of about a decade, emerging markets have gone from the "problem children" of the global economy to paragons of fiscal discipline. Estimates for 2011 by JPMorgan put the emerging market debt burden at less than 40% of GDP, while developed market debt has soared to more than 100% of GDP, up from less than 80% five years ago. Greater fiscal stability further argues for a modest increase in allocation to these countries' debt. This is particularly true given the fact that at least two of the three major regions in developed markets - the United States and Japan - have done nothing to even begin addressing their respective fiscal problems.
Finally, while investors in emerging markets were reasonably concerned about inflation in 2011, this appears to be a fading risk. Emerging market inflation did rise to more than 7% in 2011, but has since started to fall. With the exception of India, this deceleration is already evident in most of the large emerging market countries. Chinese inflation is currently running at 3.2%, half the level of last July. In Russia, inflation has fallen by nearly two-thirds, from 9.6% in May to 3.7% in February. Even in Brazil, a country with a history of stubbornly high inflation, consumer price increases have dropped to 5.8%, down from 7.3% in September. International Monetary Fund estimates suggest that this trend should continue, with emerging market inflation falling throughout 2012.
Despite the improvement in fundamentals, emerging market bonds are offering a significant and historically high premium over most developed market debt. Currently, emerging market bonds are yielding roughly 350 bps over the 10-year Treasury, close to a record high (see figure10).
While emerging market bonds are still more volatile than domestic, they add diversification and - for those willing to accept additional volatility from currency exposure - a hedge on an erosion in the dollar. For those still wishing to avoid the foreign exchange exposure, there are dollar-denominated bonds and funds that offer the incremental yields without the foreign exchange risk.
Necessity is the mother of "taking chances."
Whether by design or as an acceptable casualty in their attempt to cushion the aftermath of the financial crisis, developed market central banks have confronted fixed income investors with a difficult choice: Move further out on the risk curve or accept lower yields. Ultimately, the choice of risk needs to be set by each investor based on their investment objectives and risk tolerance. For those willing to take on marginal risk, there is still the decision of which risks to take.
We believe that it would be a mistake to seek incremental yield in the form of longer duration. While yields could certainly go lower in the event of another crisis or a sustained bout of deflation, long term we would argue that there is a greater risk of inflation than deflation. And while it is true that a combination of public sector buying, pension sector need for long-duration assets and simply the diminishing pool of "safe" sovereign plays is likely to keep yields low for some time, given high duration levels, even a modest backup in yields will induce significant losses.
Instead, for investors willing to accept higher risk we would advocate adding modestly to spread products. In particular, we would highlight U.S. investment grade and emerging market opportunities. Both segments of the fixed income space appear reasonably priced, and evidence solid fundamentals. The risk is that both are, to varying degrees, vulnerable to another bout of risk aversion. But under that scenario, as last summer demonstrated, there is little to do other than follow the Fed and load up on Treasuries, at any price.
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