We are at a critical juncture in the fixed income markets. We believe the answer to three key questions will become clear over the coming months, so we will remain heavily in “cash” over the near term in order to take advantage of opportunities that occur as we get clarity. In all of our analysis, we strongly believe that treasuries are at artificially low yields, and if they were truly “market priced” right now, they would be yielding significantly more. That view impacts all our allocation decisions as any developments that reduce the Fed’s direct involvement in the market will have a disproportionately large impact on prices.
The 3 big questions that we should get more clarity on are “How strong is the US economy?”, “Is the next round of European Debt Crisis already here?”, and “How will China land?”
How Strong is the US Economy?
The really strong and a return to consistently good growth depends on the view that the jobs data has been right and economy has turned corner and the strength in jobs will translate into other areas – the housing market in particular. If this is the case, then QE may be off table, treasuries will sell off dramatically (the 10 year could easily go to over 3% in a short time frame as it is artificially low and even extremely low short term rates can’t anchor the longer dated bonds without QE). This would be good for credit spreads, for banks and high yield companies in particular.
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 is still on table the sell-off is muted, and credit spreads do well.
The economy may have already seen all the growth it is going to get, and will slump as businesses wait to see if real demand occurs to justify their hiring. We think this is the least likely of the scenarios, but would be good for treasuries and would see a sell-off in credit spreads. The rally in treasury is still likely muted, as we are still close to the tight end of the range, and really need problems in Europe rather than domestically to cause a big move higher in treasuries. Credit spreads would be affected across the board.
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 US from Europe’s woes.
Everyone else’s base case seems to be that LTRO, firewalls, and revised budgets will work and keep European problems contained. This could see continued improved in credit spreads, but here the separation of the US and Europe comes into play and limits the positive impact as so much of that has already been priced in, and the market really isn’t that concerned about Europe. This will be bad for treasuries, but the real move to the downside in treasuries is very dependent on QE, so the sell-off will be minor. German and French yields could get punished.
How will China Land?
Will the landing be hard or soft? This still seems like a coin-flip to me. The data continues to be weak, and with my view that Chinese data is manipulated, the real weakness in the economy may be worse than we realize. But even if China is headed for a hard landing, they are likely to manufacture some data in the near term that tries to calm markets, and they have their own central bank tools. A hard landing would be bad for risk assets, and a soft landing would be good. I think either could occur, that I believe soft landing is the scenario the market has priced in, so the downside risks from China remain greater than the upside opportunities for risky trades. For treasuries, a hard landing would create some strength for treasuries, but at current yields, how much do they benefit, and there would be concern that China starts selling more of its treasury securities in an effort to pump money into their own economy.
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. Just look at the 10 year treasury. When I wrote my first draft of this piece, the 10 year was yielding 2.15%. At that yield, one month’s interest is only 0.18%. If the 10 year moves 0.25% in yield in the month, that move is about 2.15 points. So an entire year’s carry is lost in one move. As I finish this version of the report, the 10 year closed at 2.21% and had a swing of 0.75% from high to low. We want to have money on the sideline to be able to buy up treasuries if they get that big sell-off, or to add to credit products if those get cheaper. Even in high, investors overestimate the opportunity cost of sitting on the sidelines briefly. Even HYG, yielding 7.27%, one month’s interest is only a 5/8% move in price. HYG is up almost 10 points from the lows of last fall and the high yield market is showing signs that it has gotten tired. A 2% to 3% minor pullback is definitely possible and being able to capture that move is very valuable. We may leave something on the table by not being fully invested, but believe that this strategy provides the best risk/reward profile for the start of Q2.
On Friday I had the opportunity to be part of a Q2 Asset Allocation Strategy Discussion on Bloomberg “Street Smart” with Trish Regan and Adam Johnson. It was a good look at the outlook for stocks and bonds, and actually has a nice chart of the asset allocation at the 3 and a half minute mark.
15% to Leveraged Loans. I would go with mutual funds as there is no viable ETF, and I don’t like the closed end funds for loans right now, as they trade close to NAV or at a premium, use leverage, and often excessively sacrifice credit quality for current income. I like leveraged loans because if we get improvement in the economy, the expectations of interest rate increases could provide a strong bid for floating rate loans, and if we get another severe downturn, they should outperform because of the senior secured nature, and unlike 2007 and 2008, they are not overbought on leverage. There are some concerns that credit quality is deteriorating as the market sacrifices covenant protection and safety for increased yield, but it doesn’t seem out of control yet. Also, with CLO’s starting to heat up again and the potential for ETF’s in the leveraged loan space, this asset class could see a pick-up of in-flows and investor demand.
15% to high yield bonds. A little more current income, higher beta to an improving economy, and if concerns about Europe remain mostly isolated to Europe, the spreads should hold in. High yield will be less affected by any sell off in treasuries and the spread tightening would offset a lot of, or even all of the move in treasuries. HYG and JNK are good proxies for the market. I like HYG better, as I think their share creation/redemption process is more diligent than JNK, and that can be an issue in a big move, especially a surprise one to the downside. At these yields, individual credit selection and in fact, individual bond selection can be a big driver in the returns, so looking at mutual funds or specific bonds also makes sense. At times of market turmoil where beta will drive returns, the ETF’s serve a very useful function, at times when the market is toppy (as it seems now), looking for expert portfolio management has it’s benefits.
5% to US Financials. These still have some value. They don’t have much European exposure. I would not touch European financials here, but US ones could be worth having a small allocation. MONY is a new ETF, but too small and unknown portfolio to recommend. If you buy single bonds, I would look closely at some of the inflation linked bonds. MS has one that pays CPI+200. You are taking some credit risk but have some inflation protection at a better yield than TIPS, and it does seem that US banks will not get hurt as badly in another wave of European debt concerns, and could actually do well if we get a round of QE targeted at mortgages.
5-10% to TIPS: I prefer the corporate CPI linked bonds, but TIP’s is an okay allocation. I don’t believe that there is no inflation or limited inflation, and think that TIPS (either bonds or ETF’s) offer some protection and can do very well if all the printing finally causes a global spike in inflation. It is consistent with the theme where both leveraged loans and high should do okay in an inflationary environment.
5-10% to Emerging Markets: I look to the ETF’s as these are a trading vehicle to me, and this is more of a macro/beta call than one that demands specific credit selection (at the potential expense of liquidity). EMB is bigger and more liquid than LEMB, but is only dollar denominated bonds; whereas LEMB is local currency bonds. Right now I prefer LEMB to EMB.
5% to down and dirty RMBS/CMBS. No good way to play this without finding specific bonds since I have no interest in “vanilla” high quality mortgage bonds, here I’m looking for high beta, low dollar price paper, where mere stability in the housing market and working off the foreclosure inventory can get you paid back at a nice premium to purchase price. Extremely high beta, but is how I would play the recovery in homes as the downside seems largely priced in. This part of the market is still in the “don’t touch” category for big institutions, but if that stigma goes away, we could see a small bounce turn into a chase for returns very quickly. Being right in cheap illiquid paper has its benefits.
40-45% in t-bills: And I mean t-bills. I don’t like money market funds here. They have a tendency to drift back into things like European bank paper to cover their costs, and I do not want that. This is meant to be money availbalbe to re-allocate as the questions become clear. Too many investors get scared of missing yield or the carry. Don’t. There should be good opportunities in this quarter to put the money to work and outperform a fully invested strategy.
0% to Investment Grade: I would avoid investment grade bonds funds and LQD on the ETF side right now. The yield risk cannot be made up by the spread improvement for this class. Investment grade spreads have compressed a lot, so they have limited ability to rally more (particularly away from financials), so the returns will be largely dependent on moves in treasuries, and I am too scared of a back up in rates to participate in investment grade credit. I have seen the “decompression” trade at work in CDS land, where IG CDS has outperformed HY CDS, so again, too much is priced in even in spreads, so stay away from IG bonds right now.
If Europe succeeds in stabilizing, I would look to buy Italy. Potentially big returns, but too risky right now. I think Italy has more ability to avoid a restructuring than Spain, so Italy is the one I’m watching for an opportunity to buy. Now is not the time, and if anything a short position in Spain is warranted.
I would not buy any of these strange bonds that are being flogged to retail investors. If you see a bond offering that says: range accrual, Inverse floaters, or something equally esoteric, run for the hills. And the higher the initial coupon, the faster you should run. Incredibly mispriced for the retail investor.
Thanks again, and good luck in Q2.