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Market Commentary: Understanding Fixed Income

Market Commentary: Understanding Fixed Income

April 18, 2020
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To begin this week’s market update, let’s review the timeline we’ve been following for the past month or so. Last week, we mentioned that new cases were peaking and expected the daily death rate to do so as well. We are still on track, and our timeline indicates the U.S. will begin to relax the shutdown near the end of April (the key word being “begin”). This, too, is on track.

Daily new cases and daily new deaths are now declining. Yesterday, there was a spike, but the New York Times reported a change in the way the COVID deaths are calculated. [1] Quoting the paper: “New York City, already a world epicenter of the coronavirus outbreak, sharply increased its death toll by more than 3,700 victims on Tuesday, after officials said they were now including people who had never tested positive for the virus but were presumed to have died of it.” 

Whether you agree with the rationale or not, it should be a one-time spike, since this brought forward previous deaths. 

Signs of Relaxing the Shutdown Grow 

Leaders are already suggesting they have plans in place to relax the government shutdown. Republican governor of Texas Greg Abbott said he plans to allow businesses to reopen with an executive order that would lift the coronavirus lockdown in a "safe" way.[2] Details of the order are expected to provide businesses with a list of guidelines (including testing) on how to safely reopen. The governor announced that Walgreens locations would soon offer a test that can be administered via the drive-thru window and will provide results within 15 minutes.

The President and Administration will be watching closely. He mentioned this would be his toughest decision of his administration to date.

Perhaps most notably, the Washington Post earlier this week leaked a draft plan to reopen the economy.[3] The plan would open childcare facilities first, and areas least affected by the virus would open sooner with preference for areas with robust health care system. Testing and monitoring would be required.

An Eye on Sweden

There are growing reasons to begin relaxing the shut down, but there is still the fear of a second wave.

Sweden did not issue Stay-At-Home orders. This may provide insight on how much of the slowing of the virus was natural versus government intervention. If Sweden has a similar experience as other countries, then this could suggest the slowdown in the US and others has run its course, and a significant second wave is less likely.

If Sweden has a worse go of the virus, then that would represent the remaining susceptible population and the possibility of the second wave. Remember, the flattening-of-the-curve only slowed the pace of infection. The same amount of people will still need to be infected for the virus to abate.

So, we have an eye on Sweden.

OPEC’s Deal to Cut Production

While everyone’s been focused on COVID-19, our attention is shifting to the oil price war. The OPEC deal to cut oil production, we believe, is lacking.

OPEC+ will cut 9.7 million barrels a day -- just below the initial plan of 10 million. However, in a world where there is now up to 36MMb/d less oil demand, it is not enough. In addition, Mexico was considered the winner in the "Mexican Standoff" With Saudis. Mexico is cutting just 6% of production, or 100Kb/d, instead of the 23% for other members.

The cuts leave the US as the biggest producer of oil. [4] The US claims an organic decline by 2mmb/d over the next two years, unless prices rise and additional shale oil comes on to market.

Our take? This is the second time in less than five years that Saudi Arabia has attempted to control prices through production cuts. The oil cartel now has many more players with too many other options. Game theory would suggest as more players, the less effective the cartel due to cheating. We are in agreement with Goldman Sachs’ call of short-term $20/bbl forecast.[5] This is a supply shock, so the way out is to increase demand or the slow process of driving high cost producers out of the market.

However, we think the demand story has potential.

Stimulus Package Update

Since September, the Stimulus provided through Fiscal and Monterey policy is staggering:

  • The recently passed CARES Act was $2.2 trillion.
  • The Fed will make up to $4 trillion in loans to businesses to rescue the U.S. economy.
  • Then, there’s the $2.3 trillion in additional programs the Fed announced on Thursday, April 9th.
  • Finally, the Fed’s QE program, which returned in the Repo Markets in September, has been estimated at another $2 trillion in bond purchases.

Altogether, the total sum amounts to $10.5 trillion. This is approaching half the US GDP. This certainly could drive demand up.

Also worth noting is that many are receiving their stimulus checks this week. Please check your bank account you used for filing your taxes to see if you have received a stimulus check.

Inflation

In our previous call, we mentioned inflation risk is high (but not certain), as well as the belief that bonds are overvalued and equities are undervalued.

First, let’s discuss the purpose of bonds in an investment portfolio. They are used to reduce uncertainty, which dampens volatility in a portfolio in the short-term. To better understand this and how we are approaching bonds, let’s review the characteristics and risks of bonds.

Bonds have contractual obligation, which are known beforehand. This is why they have greater certainty than stocks. Here is an example of purchasing a $1,000 bond with a 5% coupon, paid over 10 years, with the original purchase amount returned and the final payment.

These are all known beforehand and contractually obligated. So long as you do not sell the bond, this is what you will receive. Nothing more or less — except, if the bond defaults. If you buy government bonds, there is no risk of default, but this is not to say there is no risk.

Inflation Risk

The first risk we will discuss is inflation risk. In theory, there should be a natural or real rate of interest plus an inflation premium. Together, they equal the Nominal Interest Rate, or the coupon at time of issuance.

We believe inflation risk is high; however, treasury yields are currently below the low inflation rate. Whether high inflation is realized or not, a 10-year treasury is losing purchasing power in the current low inflationary environment.

 

JP Morgan has a great slide on this reality. We know the nominal yield of a 10-year treasury at the end of March. It was .7%. Not 7, .7%. Using the previous equation, we can subtract current inflation of 2.37% and determine the Real Yield is NEGATIVE 1.67%.

 

Or we can look at a different way. The blue line is the current yield curve. The dotted line is the yield curve in December of 2013. It shows bonds ranging from 3 months to 30 years. The fuzzy line is the current inflation rate, and all treasury bonds are below inflation rate. It does not matter the term.

Despite certainty of meeting the contractual payment obligation, if inflation was to stay at this level, a 30-year bond (before taxes) would lose 35% of its purchasing power by the time it matures. That is approximately the same loss in the S&P 500 from its February high to recent low. Once again, this is at today’s low inflation rate.

Credit Risk

Not all institutions are able to print money and, therefore, guarantee payment. To compensate for this risk, a risk premium is added to the nominal rate of the bond. In theory, you would increase the yield of the bond by the probability of default.

Assume one payment is expected to be missed. You would then increase the other payments to offset the default. In the end, the received money is expected to be the same as a similar termed treasury.

Now this is an oversimplification. A bond is unlikely to default on a single payment and never pay it back. And they could default all together. However, this concept works well across multiple bond issues.

Also, this is important for later, forecasting defaults is never accurate and most assume higher defaults than what will be realized, so a bond investor ends up receiving more money than similar termed treasuries.

We have covered two bond risks both dealing with payment. The return of your money and the purchasing power of your returned money. Let’s move to the third risk.

Interest Rate Risk

This risk is best divided into two separate components: Bond price risk and Reinvestment Risk. The duration (defined later) is what separates the two. This is often depicted with a teeter-totter and the board shows the direction of your account value over time.

 

Using the previous example, if you bought a bond paying a 5% coupon each year, you will get $50 each year and the last year receiving your original $1,000 plus the final $50 payment.

But what do you do with each $50 payment? If interest rates stay the same, you could invest them in bonds paying 5% as well. Your compounded rate of return will be 5%. The board would be level at a 5% compounded rate.

In a rising interest rate environment, you want less bond price variability (short duration) to take advantage of reinvestment risk or opportunity. You want to ensure you receive your money back, (higher quality), and you need to offset (inflation), which most bonds are not doing at this time, indicating significant overvalue. With the market also coming off of a bear selloff and deemed undervalued, we favor equity.

Rate Sensitivity

Let’s look at the interest rate sensitivity of the different bonds. Assuming a 1% increase or decrease, treasuries could rally, but only the 30 year is positive after a 1% drop. A mere 1% increase on a 30-year Treasury would have a price drop of 21.31% or a bear market in treasuries.

Corporates, Convertibles, High Yield and Floating Rate have better downside protection.

US Treasuries do not meet our criteria.

They have high quality, but fail the other three.

US TIPS are better.

They mitigate inflation by linking to the CPI, but this assumes the CPI reflects the basket of goods you purchase. There has been a lot of tampering with this index to mute the increases. I would rather have the PPI as the price escalator, but they are better than plain vanilla treasuries.

Corporate Bonds pay higher than the Treasuries.

However, they are near inflation, so there is little mitigation of the risk. They are higher quality, so long as they are not below investment grade. The other two are not met by all corporate bonds. If they have high equity correlation, then they likely have low quality. And shorter duration paper will likely pay well below inflation.

Floating Rate Bonds are better than Fixed Rate.

The rates adjust, so if inflation were to increase, it should move rates up. Many bonds are already paying below inflation. Nonetheless, the bonds do adjust the rate, so the duration is near zero. Their quality is similar to junk bonds and is often subordinated debt, so we do NOT meet the credit quality requirement. They are used heavily by energy companies —specifically, shale.

High Yield Bonds meet many of the requirements, but for all the wrong reasons.

Their yields are high because the default risk is high, so credit quality is low. The higher yield does shorten duration. Plus, the default rate is highly correlated with the ability of the company to pay meaning strong companies. Strong companies have rising stock prices. And vice versa, this is not how you want to get equity correlation.

Convertible Bonds are unique and useful.

These are instrument and one we favor coming out of sharp selloffs. They are a combination of a bond, which acts as a floor, with a call option on the stock.

Convertible Bonds meet all four criteria.

They have a synthetic equity component that allows for conversion to equities, which helps mitigate inflation risk. The bonds tend to be non-rated. Many assume they are junk, but often they are the highest quality bonds. This is the reason well-known companies (e.g.m Salesforce) use converts to avoid paying a rating agency hundreds of thousands of dollars for a rating, since the market is already familiar with them.

The converts market has historically had a relatively low default rate (1-2%) compared to the high yield market (4-5%). Due to the conversion option, most are converted to stock and never mature so it is difficult to assign a duration, nonetheless, they have characteristics of shorter duration bond funds. The equity correlation is high when stock prices are high, since the conversion option is more valuable. When stock prices are low, then the bond acts as a floor and they trade more like bonds.

To recap, we are currently using the convertibles as a way of tilting from fixed income to equities, but long-term we expect to move to actual equities. But this would get into our Investment Policy Statements, which we will save this for another client call.

For more even more detail on the different types of bonds and how they behave, please reference our video recap, which will be posted in the next week.

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Important Information

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

This Research material was prepared by the financial professionals at Gatewood Wealth Solutions. All information is believed to be from reliable sources; however LPL Financial and the financial professionals at Gatewood Wealth Solutions make no representation as to its completeness or accuracy.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC.

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Sources:

[1]https://www.nytimes.com/2020/04/14/nyregion/new-york-coronavirus-deaths.html?campaign_id=60&emc=edit_na_20200414&instance_id=0&nl=breaking-news&ref=cta&regi_id=90648228&segment_id=25162&user_id=6b5d1c1daf79a036a6bfb052b43aec3b

[2]https://www.newsweek.com/texas-ease-coronavirus-lockdown-under-executive-order-restore-livelihoods-governor-says-1497371

[3]https://www.washingtonpost.com/health/2020/04/14/cdc-fema-have-created-plan-reopen-america-heres-what-it-says/

[4]https://www.investopedia.com/investing/worlds-top-oil-producers/

[5]https://www.cnbc.com/2020/03/17/goldman-slashes-oil-forecast-sees-us-crude-at-22.html

 

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