Fixed-Income Market Commentary Archive

Key Points:
• Treasury investors benefit from global economic and military concerns
• Two high yield managers weigh in
• Inflation continues to decline

Well, so much for all the talk about trillion dollar budget deficits and rising inflation forcing Treasury rates higher. It seemed that just about everyone (including me) was expecting a period of rising Treasury rates this year, but in May the market turned and headed in the other direction. Treasury yields hit their low point for the year in May in response to market volatility that came back with a vengeance. That volatility was influenced by a correction in the equity markets, continued concern about the spread of Euro-zone weakness and military / political concerns out of the Korean Peninsula. The result was yet another investor demonstration showing that the dollar and Treasury market remain the asset class of choice and liquidity in times of fear and uncertainty. Throw in another low inflation report and Treasury investors had nothing to hold them back.

The Treasury Department was a big beneficiary of this move as it auctioned off a new wave of debt in the final week of the month at some of the lowest rates of the year. A total of $113B was spread out among 2, 5 and 7 year maturities. The Treasury index we follow, which has an average maturity of 6.6 years, logged a return of 1.7% in May. Individual Treasury benchmark securities such as the 10-year and 30-year maturities returned 3.1% and 5.4% respectively for the month.

So why is Treasury debt always the target in a flight to quality environment? Because Treasury debt, unlike other fixed income asset classes, is quick, easy and safe to pile into for institutional investors. That and the liquidity characteristic of the asset class is why it remains the flight to quality destination for large institutional players. By way of comparison, the municipal bond market is much more fractured. Consider that in all of May there was ~$23.2B in negotiated new issue municipal bond volume brought to market. This was spread out among almost 300 different issues. Obviously this pales in comparison to the $113B Treasuries in the final week of the month and this becomes an obstacle. Corporate bond issuance was down sharply in May, but still totaled roughly $66B – much of it below investment grade rated and therefore not targeted in the flight to quality.

In reviewing the fixed income markets, I can say that a renewed concern about too much debt in developed economies around the world is putting pressure on some segments of the market. It seems many nations have an economy that it turns out may have been primarily supported by governments, as well as individuals, who have assumed excessive amounts of debt to maintain a certain lifestyle. Sound familiar? Now that bond investors are paying closer attention to those debt levels, some governments are scaling back spending (austerity plans?) and that reduction in spending leads to… economic contraction.

Risk avoidance returned to the domestic credit markets, too. This is highlighted by increasing spreads (additional yield above risk-free Treasury rates) in corporate bonds. Both investment grade and speculative grade rated corporate bond indices posted negative returns in May. This is another indication of the flight to quality, although it could easily be argued that the high yield market was due for its own correction after the index returned almost 29% in the past 12 months.

During the month we spoke with two high yield fund managers. I met with Margie Patel of Evergreen Investments, a Boston-based fund manager who visited our offices in Wellesley, MA. Margie, who has experience and an impressive track record in the high yield space, tells me one of her methods of evaluating the high yield sector is to watch the average dollar price on the index. She explains once it reaches a level around $103 or above, it is an indication that high yield is fully valued. At month-end (and after a ~ 3.6% index sell-off) the average dollar price of the index was just over $95.

Meanwhile my colleague Jeff DeMaso had the opportunity to speak with Sandy Rufenacht of Three Peaks Capital Management. Sandy is a high yield manager known for his conservative portfolio positioning. He says the high yield market of 2008 was probably not as bad as it felt and 2009 was not as a good. He expects the period of 2010-2012 to be a smoothing of the average. While Sandy acknowledges global concerns, he believes the fundamentals are good for the domestic component of the asset class. This includes cash on corporate balance sheets and declining default rates. He is also seeing strong new issuance and a market that is being supported by positive flows from investors. This leads him to claim that high yield is in the sweet spot at this time.

Regarding inflation, which is a big negative for bond investors, recent data suggests that inflation remains tame – very tame to the extent that we may well have a period of deflation (as it is officially measured anyway). A note from an economics team we follow says that in May, “core CPI came in flat for the second consecutive month against a consensus that was looking for a 0.1% increase. On a year-over-year basis, core consumer price inflation is running just 0.9% – well below the Fed's implicit 2% target and something we have not seen since the mid-1960s. No matter how you slice it, inflation has a downward trend. Housing has been the epicenter of the crisis and constitutes a 42% share of the CPI basket. This is why it does not make much sense to simply exclude it when analyzing the inflation data.” From my perspective, this is just one more reason not to fear holding the right mix of fixed income positions at this time.

I do believe that the market will eventually take rates higher even if the Fed does not. For the immediate future, inflation concerns will not be a significant part of that reasoning. I do expect to see inflationary pressures at some point and will address it once we see it start to creep up. In the interim, investors who have been waiting for rates to rise before committing may well be in for a longer wait than originally thought. There is a cost of waiting and it is keeping money invested in money markets with next to no return.

So, what are the available options for cash amongst classes of fixed income funds? Short-term duration funds are an option if there is a concern about rising rates. There are also intermediate term bond funds. An appropriate allocation to high yield funds can provide more conservative exposure to high yield bonds. As for Treasury investments, with rates at or near their lows, consider avoiding them if your mandate allows. Otherwise, also relevant for your consideration are individual investment grade rated bonds, both tax-exempt and taxable and tax-advantaged agency debt.

Kobren Insight Management may have investments with both Three Peaks and Evergreen funds, however we are otherwise not affiliated with those firms.

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