Income Investor Perspectives

A recent Wall Street Journal article (“A New Mystery Bedevils Fed Data,” WSJ November 10, 2015, by Katy Burne; link provided for subscribers) draws attention to recent data provided by the New York Fed,

Large U.S. banks reported negative corporate-bond inventories for the first time ever by one measure, the latest twist in a market being remade by rising investor demand and declining stockpiles at dealers that buy and sell the debt.

The figures are being closely scrutinized on Wall Street amid concerns that liquidity, reflecting the capacity to buy or sell quickly without moving market prices, has been in decline and could become more challenging as the Federal Reserve prepares for its first interest rate increase since 2006.

Any bond market participant would likely agree that this reflects the current reality of reduced liquidity.

The New York Fed data has been used as a proxy for dealers’ wherewithal to facilitate client bond trades.

“The regulatory environment has caused dealers to change how they trade and position corporate bonds,” said Andrew Brenner, head of international fixed income for broker dealer National Alliance Capital Markets.

Yes–liquidity in the cash bond markets is much different and much less than it has been in the past, and that has been driven (or accelerated) by the regulatory changes. The regulatory changes affecting dealers, however, do not have a direct impact on demand–some of which has shifted from direct ownership in bonds to exposure through ETFs. Because many investors are now accessing the bond markets by using ETFs, when there is a need to adjust a portfolio, if the adjustment is done by using ETFs, the portfolio shift may no longer create trading flows through the books of over the counter bond dealers.

As a result, the liquidity experienced by an investor who has exposure through bonds and ETFs may not be as constrained as would appear from the Fed data about the bond dealers.

Keep in mind that liquidity in fixed income ETFs arises from demand for the underlying bonds as well as from a broad variety of ETF market participants: the Authorized Participants, equity market traders, speculators and hedgers, as well as other investors using the ETFs as a tool to access the bond market.

At the macro level, this question really needs deeper analysis, looking at a combination of over the counter flows and ETF trading flows, as well as creation / redemption activity.

At the micro level, investors need to be thinking in advance about their future liquidity needs and plan their portfolio implementation in advance–before they add positions. 

For additional comments on liquidity and portfolio implementation, see my earlier article Bonds are not Stocks.

*Even if your clients do not own Puerto Rico municipal bonds.

Are you prepared?

If you have tuned out all of the news updates about Puerto Rico’s municipal bond and finance problems, it is time to tune in again.

There is speculation of an increased risk of a default by the Commonwealth on December 1. If that happens, there will be headlines in every periodical, and the stories will include the words “municipal bonds” and “default.”

If you have muni bond clients who read those stories, you should be prepared for their questions, should they call you:

• What does this mean for my municipal bonds?
• Should I be selling my muni bonds? Should I be buying?
• What does this mean for the rest of the municipal bond market?
• How will this affect my muni bond mutual funds? (Or ETFs?)

For clients who may already be uncomfortable with the bond market generally or the muni bond market specifically, headlines like this could provide a distorted impression of the market-at-large. We can all hope that there is not a default on December 1, but advisors would be wise to be prepared for well-informed conversations should it happen.

Keep in mind that by December 2, there will only be a few full trading days left in the year, so secondary market liquidity may be reduced and volatility could be heightened–raising the risk of an emotional (that is, less than rational) response from investors which could add to volatility.

Be Prepared:

Identify which of your clients own Puerto Rico bonds. Are any of them un-insured?

Review municipal bond mutual fund holdings for exposure to un-insured Puerto Rico bonds. What are those managers saying about their funds and Puerto Rico exposure?

If your clients use municipal bond SMA managers, be sure that they are keeping you updated with their views of the potential impact on the market and actual market reactions.

Visit The Wall Street Journal, Bloomberg.com and Morningstar.com for their latest updates. (Or to catch yourself up, if you have tuned out on this topic.)

What does your firm’s research department have to say? Have their most recent research report handy to share with clients.

Determine if you will want to make pro-active calls to some of your clients.

Finally–block off some time in your calendar so that you will be able to be fully engaged with clients who need your guidance.

This is not a suggestion to buy, hold or sell Puerto Rico bonds–nor is it an opinion on the credit risk or likelihood of credit deterioration or default. This is only a recommendation to be paying attention to what is happening, because the constant drumbeat of news about Puerto Rico municipal bonds may have overwhelmed advisors’ and investors’ awareness. If the pace or gravity of the news flow changes, it is best to be prepared so as not to be forced to be reacting to the news.

Unlike with water flowing through plumbing, bond market liquidity is very difficult to measure.

Most traders and portfolio managers would agree that liquidity is influenced by many factors, and can change quickly. (Even the definition of liquidity is open to debate. Here, I define it simply as the ability to easily convert an investment into cash. Some participants add the qualifier that a security is liquid when it can be easily traded without dramatically affecting the prevailing market quotes. I omit that from my definition, since in the bond market, many securities are quoted only when a trade is contemplated.)

Planning for liquidity is a crucially important component of portfolio management, particularly since accepting some degree of illiquidity in exchange for higher yield is a common tactic. (As with other investment risk factors, liquidity risk should be priced into the yield demanded by an investor considering a bond investment–the greater the risks accepted, the higher the yield that should be expected. Unfortunately, there are many examples of yield hungry investors having given into the temptation of stretching for higher relative yields, not realizing until much later that they had unwittingly accepted greater liquidity risk.)

An incomplete and distorted view of bond market liquidity, however, is depicted in “The New Bond Market: Some Funds Are Not as Liquid as They Appear,” The Wall Street Journal (September 22, 2015). (Link for subscribers.)

Some of the largest U.S. bond mutual funds have invested 15% or more of their money in rarely traded securities, a practice that runs counter to long-held Securities and Exchange Commission views on the funds, an analysis by The Wall Street Journal shows.

The finding is one indicator of inconsistency in how fund managers calculate the liquidity in their portfolios, a hot-button issue for investors and regulators. By the Journal’s measure, 10 of the 18 largest funds that invest meaningfully in corporate debt have significant holdings of seldom traded bonds.

According to The Federal Reserve Flow of Funds report (September 18, 2015, Table L.208), there are $11.8 trillion of Corporate and Foreign Bonds outstanding in the United States. According to data from SIFMA, in August of this year, Average Daily Trading Volume of U.S. Corporate Bonds was running at $18.6 billion–or approximately 0.2% of the total outstanding. So does that mean that 95% or more of the corporate bond market is illiquid because matching CUSIPs did not trade that month? Hardly.

To be sure, some bonds don’t trade because fund managers value them highly and could easily be sold if need be. Loomis Sayles sold a roughly $96 million Ford Motor Co. bond investment within five days, while the Journal’s analysis indicated it would take 65 days.

The Journal analysis concluded that a single Ford bond would take 65 days to transact? For one of the largest and most widely held bond issuers in the market? Clearly, the Loomis Sayles portfolio manager and trading desk did not rely on a similar analysis.

This is not to suggest that examining liquidity is not a worthwhile topic–it is a very important topic, especially now with the nature of the bond markets having changed and continuing to evolve quickly. Bond investors are able to compare many characteristics of their investments–yield, duration, credit risk, etc., but liquidity defies easy quantification. Investors (and journalists) and reminded that bonds are not stocks, and trying to apply a stock market perspective to examine the bond market can lead to incomplete (or erroneous) conclusions.

For those interested in digging deep into the topic of bond market liquidity, there have been some excellent articles published by a number of firms, of particular note is a July report from BlackRock, “Addressing Market Liquidity.”

What do you think?

The total return king yesterday (Monday the 24th), was the Barclays U.S. Treasury: 20+ Year index, with a one day total return of 50 basis points. The loser, as you might expect, was Barclays U.S. Corporate High Yield which dropped 81 basis points on the day. (My observations are based on Barclays Index Returns, which are updated daily.)

After the violence in yesterday’s markets, some investors who had forgotten about (or drifted away from) the benefits of diversification may be thinking today about which bonds to add to counterbalance their equity allocation.

Do not be tempted to take on a new bond position based only on recent returns, but take a page from how professional portfolio managers make decisions. A professional manager is seeking to manage risk exposure—not to eliminate risks, but to mitigate some risks, while using other risks to seek incremental return. The manager’s investment process seeks to evaluate the potential reward associated with foreseeable risks—“buying” some (overweighting) and “selling” or hedging others (underweighting). Generally speaking, if they have money to put to work, they don’t look at the market and decide whether or not to invest today. Instead, they are more likely to ask, based on what the market is doing now and what they expect in the future, what is the best investment that they can make today?

For investors* seeking to diversify their portfolio, here are a couple of key points:

• First and foremost, your portfolio should reflect your goals as defined by your investment plan or policy.
• Do not chase returns. (In other words, duration may have been king yesterday, but not necessarily today or tomorrow.) Past performance is an important data point to consider, but not the only one.
• It is impossible to know the future–hence, diversification is as important to investors as car insurance is to drivers.
• Before you make any changes to your fixed income allocation, read about How to Time Interest Rates and to get a sense of the process used by full-time portfolio managers, the Benefits of Professional Management.

*These comments are relevant to investors–those with a longer-term investment horizon. Traders will have a much different perspective.

The information contained herein is based on sources believed to be reliable, but its accuracy is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

Are you using the rearview mirror to figure out where you’re going?

How can an investor measure risk? To non-professionals, duration and standard deviation often don’t really make sense. But yield (or return) is a number that every investor understands, and is often used as the primary point of comparison between different prospective investments.

Return measures, however, are backwards looking. If you are driving, you would not expect good results by looking only in the rearview mirror. How could you prepare for the curve in the road, or the hill up ahead that obscures the view of oncoming traffic? And, what happens if a black swan happens to be crossing the road in front of you?

Historical returns are very important–but they are not the only important data point. Now is a good time to illustrate the importance of understanding what has generated returns in the past, and to have an opinion about where returns will come from in the near future.

With almost everyone calling for a hike in the Fed Funds target rate and therefore a general increase in rates, most bond market participants are counseling investors to avoid taking on maturity risk, typically described using the duration measure. (Modified Duration calculates the amount of expected change in price for a 1 percent instantaneous change in yield, and is a different calculation than Macaulay Duration which is a similar but less often used indicator of interest rate risk.)

Here are some selected figures from the Barclays Fixed Income Indices, as of July 31, 2015:

An investor looking at putting money to work in the bond market right now would be unlikely to select the 20+ year part of the U.S. Treasury market due to the very high interest rate risk–yet that same investor, if looking only in the rear view mirror of trailing returns might be drawn to the attractive 12-month returns of almost 10%. Even with a negative year-to-date return, the maximum duration (and therefore highest interest rate risk) U.S. Treasury 20+ year part of the market could be making a significant positive contribution to the 12-month trailing returns of a portfolio. (The Modified Duration of 18.39 indicates that an immediate change in yield of 1 percent would be expected to result in an over 18% drop in price. Note also that the one-month return looks attractive as well but keep in mind that the bond markets have been distorted by recent drama in Greece, so without the strong July rally, the YTD return would be even lower.) If the bond market continues on its present trajectory, most investors would expect that 20+ year part of the U.S. Treasury market will continue to underperform, dragging down the trailing performance numbers.

This doesn’t mean that investors should ignore the historical returns–but rather they should understand the components of those returns, and consider how those components are likely to perform given the current and expected market conditions.

In addition to historical returns, some of the other factors that bond investors should consider include:

• Current and expected interest rates
• Inflation
• Economic conditions
• Credit trends (perceived by the market, as well as ratings agencies and internal opinions)
• Market supply and demand, liquidity and seasonal variations
• Credit risk
• Foreign currency exchange risk

Keep in mind that when buying and holding individual bonds, the Yield to Maturity (YTM) is a good indicator of what the annualized holding period return will actually be. (YTM does make assumptions about the reinvestment rate earned on the cash flows, so final return could vary somewhat from the YTM calculated at purchase.) Read Benefits of Professional Management for some additional insight on making portfolio decisions.

It is early August, so whether you are heading out on the road for a vacation, or thinking about your bond portfolio “Keep your eyes on the road, your hands upon the wheel.” (cf. Roadhouse Blues, The Doors.)

August 3, 2015. The information contained herein is based on sources believed to be reliable, but its accuracy is not guaranteed. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Investments in bonds are subject to gains/losses based on the level of interest rates, market conditions and credit quality of the issuer. Additional information available upon request.

©2015 Patrick F. Luby

All Rights Reserved.