Fixed Income Allocation Review And Update

by: Peter Tchir

Fixed Income had a decent week. Treasuries are pure rate products were a little more volatile than more credit focused products like high yield, but in the end most fixed income asset classes had small gains. We made no changes to the allocation mix during the course of the week, but expect to make some as this week progresses.

The F words

The week will start with Firewalls and French elections. I expect the good news from the latest Firewall is already priced in. It is unclear what it does. It sounds great, but all it does is ensure that a country (or possibly banking system) that no private investor would fund can possibly get financing from an investor without a right mind (or their own money)? That new investor will typically impose conditions that actually hurt any remaining private sector investors. What happened in Greece is what will happen elsewhere if a country relies on "firewalls" and "bailouts" and waits too long to make hard decisions - including debt restructuring.

The French election results aren't out yet, but could have a big impact on the markets. If Hollande looks like the eventual winner and continues his extremely socialist rhetoric, look for markets to be weak as investors question not only France's strength but their willingness and ability to help the other basket cases around them. Belgium in particular could suffer, as both the country, and Dexia, rely heavily on French support.

As the answers to these two questions become apparent we should see opportunities to either shift allocations, or move some money from cash into various fixed income assets.

How the Debtless Affect the Debt Markets

Apple (NASDAQ:AAPL) has no debt, yet the price action of that stock and its earnings will definitely drive the price of sovereign and corporate credit globally. Whether it makes sense or not, that is the way it is in this global macro world. China, which is a net creditor, will also continue to influence debt markets. The hard/soft landing question is far from answered. The market was encouraged by statements this week that China was willing to be accommodative if necessary. That is good, but hardly surprising, and the real question is whether it will be enough.

Easy money didn't stop the 2008 crash in the U.S., and it did little last year to prevent Europe from going into a tailspin. I think once again, the market has gotten a little ahead of itself in calling the crisis "over". China's contribution to the IMF firewall seems a little secretive. Secretive in a way that indicates China is demanding a lot for their help, but the IMF was desperate enough to have a press release with a vague contribution from China rather than going into the details. It is interesting how much of an impact two entities with minimal debt have such an impact on the global price of debt.

Allocations, Performance, and What to Look For

15% to Leveraged Loans

Slow and steady continues to define this sector. Mutual funds are the best way to invest here. The leverage in closed end funds, and my perception that they sacrifice too much liquidity and quality for a bit more yield, continues to make me want to avoid them. The market as a whole churns a along. I like the senior secured nature, even if more covenant light loans are getting done. CLOs are starting to get done with more frequency, which would create a solid bid for these loans. With so many loans having a LIBOR floor, and the Fed likely to be dovish in this week's statement, don't expect any pop due to rising rates, but I continue to believe the yield vs price risk in this sector is attractive and well supported.

15% to high yield bonds

High yield performed very well. Mutual funds were up, and HYG turned in a somewhat surprising 0.5% gain on the week. If the high yield ETFs open strong relative to stocks on Monday, I would look to cut 5% of the holdings, and possibly as much as 10%. The performance has been too strong. I continue to look for opportunities to add more to this sector, but right now isn't the time, not at these prices, though I wish I had stuck to a 20% allocation longer.

0% to Investment Grade

LQD did okay last week, but it moves like a wounded treasury. It doesn't rally as strongly as treasuries, yet on weakness it declines just as fast, if not more quickly. At these levels, yields are largely floored. For a variety of reasons, but mostly regulatory capital, institutional investors struggle to allocated new money to straight bonds here. Even retail investors cannot get to excited about yields here. For "faster money" and trading types, IG spread trades may be attractive, but based solely on yield, I would not allocate to IG here, and with spreads where they currently are, I would remain on sidelines for now on a spread basis as well.

5% to U.S. Financials

I still like this sector. Earnings were not great, in my opinion, but not bad, and certainly good enough to support credit spreads here. The U.S. banks are not being dragged into the morass of Europe as quickly this time. Nor should they be, as it is clear their exposure is not as heavy as people feared last year. More weak numbers in the U.S. would be a cause for concern, but jobs and housing are okay enough to support the current valuations.

0% to Treasuries:

At this stage I would continue to have zero allocation to treasuries anywhere on the curve. I just don't see an attractive risk/reward here for the duration risk. Treasuries have performed well since their early month swoon, but largely because of horrible data out of Europe and indications that the U.S. economy is not as strong as once thought. Using the 10 year as a prime example, it seems to have hit a stage where going higher in price is a real struggle. It grinds, and is doing it, but with very little enthusiasm.

The moves down look far more aggressive. With the Fed dominating purchases, the risk of another quick brutal slide is too much. We will see how the market responds to the firewall and French elections, but this might be an actual short within the fixed income space - yes, you can be short in your Fixed Income portfolio as well as in your equity portfolio.

5-10% to TIPS:

I continue to like these, and the corporate or financial CPI bonds offer good value relative to even TIPS. The ETFs were about unchanged last week, underperforming Treasuries a touch.

10% to Munis:

Munis have some of the same problems as investment grade, that overall yields are very low, and they are moving a bit like wounded treasuries, but with tax hikes potentially on the table, and generally improving fundamentals at the state and local level, these bonds should have some support. I am a bit nervous that CDS on munis is trying a comeback. That has been a kiss of death for many markets, but I think it will not attract that much attention, so won't put pressure on munis right now.

5% to Emerging Markets:

EMB did very well last week. Best performance of the fixed income ETFs we track. Continue to like this sector, and although local currency bonds lagged and were only flat on the week, based on LEMB, an allocation to foreign currency bonds makes sense, and through a good mutual fund rather than the ETF.

0% to other Sovereign Debt:

I expect Spain and Italy to perform poorly again this week. The market will test the resolve of Europe and see where the ECB starts bidding or what the IMF says about their new firewall. I would look to allocate some money here, but not until 10 year bonds of at least one of these countries breaks 6.5%.

5% to down and dirty RMBS/CMBS.

This remains at the "hard to execute" end of our allocation. The best benchmarks remain AAA ABX and CMBX AJs. These are CDS indices, and not even the most liquid of CDS indices, but both did well last week. CMBX in particular regaining some lost ground. In no way do I think we are about to see a big rebound in housing, but I continue to believe that if housing just sits here near the bottom, the churn will allow these bonds to produce income and recoveries higher than current priced in. Also, they remain very under-owned, so in an illiquid market, the prices could bounce rapidly on any strength and some bottom feeding by funds.

35-40% to T-bills:

Having added an allocation to munis, the cash amount has dropped. I am expecting some volatility in the fixed income space this week, and will be looking for some opportunistic trading.

ETF/ Closing Daily Weekly Indicated Premium/ Fund
Index Price Change Change Yield NAV Discount Size (MIL)
High Yield
HYG 90.32 0.14% 0.47% 7.24% 89.76 0.62% 14,713
JNK 39.29 0.08% 0.22% 7.39% 39.15 0.35% 11,768
HYLD 49.75 0.10% 0.26% 8.46% 49.54 0.42% 87
SJNK 29.98 0.04% 0.20% 1.93% 29.81 0.56% 57
HY18 94.88 0.00%
Investment Grade
LQD 116.18 -0.03% 0.18% 4.11% 115.51 0.58% 20,343
CSJ 104.90 0.03% -0.09% 1.61% 104.76 0.14% 9,399
IG18 99.75 -0.25
Broad Market
AGG 110.48 0.02% 0.12% 2.64% 110.37 0.10% 14,804
LAG 58.24 -0.03% 0.04% 2.20% 58.14 0.18% 536
BOND 103.02 0.03% 0.27% 1.40% 102.98 0.04% 508
TLH 131.44 -0.04% 0.29% 2.53% 131.32 0.09% 447
TLT 117.07 0.02% 0.23% 2.97% 116.90 0.14% 2,915
TIP 119.11 0.30% 0.04% 3.26% 118.87 0.21% 22,536
WIP 60.28 0.19% 0.00% 0.00% 60.10 0.30% 1,302
EMB 113.62 0.42% 0.72% 4.71% 112.80 0.72% 4,545
MUB 109.84 -0.01% 0.94% 2.95% 109.27 0.52% 2,889
BAB 29.45 -0.02% 0.02% 5.11% 29.38 0.25% 894
Euro CDS
MAIN17 146.50 2.01 1.73
XOVER17 690.00 5.49 7.31
Click to enlarge

Disclosure: I am long HYG.

Additional disclosure: Positions change.