Timing in fixed income markets can be as important as it is in equities. With so many more liquid opportunities in fixed income now compared to the past, this is a meaningful risk management tool. This “active” component will also include ideas in equity and commodity markets as appropriate, but largely driven by activity and signals from the fixed income markets.
My firm continues to believe that we are at an inflection point in the markets. There is a real risk that the problems in Europe will escalate and that in spite of all the efforts of various parties, we will see a move towards leaving the euro and/or restructuring existing debt. This would hurt risk assets across the board, but should provide excellent entry points for committing more capital. The other scenario, that we believe is less likely, but still very possible, is that we enter into another period of calm in Europe and growth in the US remains satisfactory. In that case, as the flight to safety bid recedes from treasuries, and hopes of some form of QE diminish, treasuries will sell-off aggressively. It is not the size of the Fed’s balance sheet that matters, it is the flows, and if the Fed stops buying and the flight to safety bid goes away as economies normalize, then treasuries have far more downside from here than upside.
US Government Bonds
April Performance: The 10-year bond was up almost 3% on the month and the long bond was up over 4%. The five-year bond barely budged. Obviously it was a mistake not to be involved in longer duration treasuries during the month, but the size of the moves relative to the yields shows just how dangerous these markets are right now as the price move dwarfs the income.
Outlook: With the 10-year bond at 1.93% and the long bond at 3.12%, we are not going to increase the “core” allocation, but are looking at initiating a trading short.
Treasury Inflation Protected Securities (or TIPS): 5% to 10%
April Performance: The performance wasn’t as strong as treasuries, with the 10-year TIPS bond returning just about 2%, but they were far less volatile than treasuries, as the early month swoon did spike up concerns about inflation. Corporate inflation linked bonds, especially those issued by financial institutions, offer even better value, but at the cost of liquidity.
Outlook: Continue to like TIPS bonds and will keep the allocation constant for now. With all plans for “saving” Europe now focused on spending, there is a real potential for a global wave of inflation, though how it affects the US will at least in part depend on whether the euro rallies on being saved, or sells off due to the money printing.
This cash is there just waiting to be moved into other fixed income assets. We did make a few trading recommendations during the initial month, but it was too frequent for those who are looking for a “core” strategy, and not enough for those who are looking to manage their fixed income portfolios as actively as they manage their equity portfolios. This month, we will go back to showing more trade ideas, and will track them, and we will make a clear distinction of whether it is a short term tactical move, or is meant to affect the “core” allocation.
High Yield Bonds: 15%
April Performance: High yield had mediocre performance. Returns were about 1.25% for the two big ETFs, which seems in line with how most mutual funds performed. Concerns about Europe and slowing growth here was enough to keep spreads from tightening, but a reasonable month. The trading shifts we made here worked well, and will continue to be a focus of the trading ideas.
Outlook: The economy continues to be good for high yield bonds. The economy is strong enough that credit problems will be issuer specific and with current yields of 6.7% there is enough return potential to justify owning them here. At this stage, we would look for active management rather than an ETF or “index” return. This market is tight enough that appreciation will be tough to come by and we think an active manger with good access to new issues should be able to outperform the ETFs, which are more of a “beta” play than an “alpha” play.
Leveraged Loans: 15%
April Performance: Dull, but as expected. Funds seemed to have returned about 0.3% to 0.5%, almost all of it income as there was little price appreciation.
Outlook: Given the outlook for stable growth in the US with some potential for inflation, we may add to this category. The issue is that we don’t like the closed end funds which use leverage, and the managed funds can be good, but are harder to move in and out of, so we want to be sure about increasing the allocation, acknowledging that this is a less liquid area.
Investment Grade: 0%
April Performance: Surprisingly weak. Using iShares iBoxx $ Invest Grade Corp Bond
(LQD) as a benchmark, the return was only 1% for the month. The Merrill Lynch Investment Grade bond index also came in at 1.25%. Basically spreads widened as the returns couldn’t keep up with treasuries, which was our view all along. The total return here was less than high yield or treasuries.
Outlook: Continue to avoid as yields can’t compensate institutional clients with regulatory capital constraints.
US Financials: 5%
April Performance: US financials returned 0.75% according to ML bond indices. They lagged the broader corporate market as concerns about Europe put pressure on them.
Outlook: Continue to like this sector. Earnings were fine. The industry is still under pressure in terms of growth, but from a credit standpoint, stability is more important than growth, and any rebound in housing will be a catalyst for spread tightening.
April Performance: We just added these on April 23, so caught virtually all of the 0.9% return. Munis suffered a similar fate as investment grade. They just couldn’t keep up with treasuries. BABS did manage to return 1.75% as the higher coupon and some allocation from institutional investors helped that market outperform – on a pre-tax basis.
Outlook: We will wait for a sell-off in treasuries before increasing the allocation, but the economic backdrop seems to be fine for municipal bonds in general.
Other Fixed Income Allocations
Emerging Markets: 5%
April Performance: iShares JPMorgan USD Emerg Markets Bond
(EMB) came in at 1.8% as emerging markets weren’t affected by problems in Europe, though the local denominated indices returned 0% for the month.
Outlook: We may look to grow this again, particularly on the local currency side, but are waiting for elections in Europe to see what impact those elections have on sovereign debt globally. Similar to high yield, active management should add value here versus the index, so we would look at good managers to make the allocations to.
Other Sovereign Debt: 0%
We continue to watch Europe and think there is a risk of another leg down as problems in Spain and Italy mount, and concern is flip-flopping between whether it is a sovereign problem, a bank problem, or both. If QE is really off the table, we could see dollar strength, another reason to hold off on any foreign bond allocation.
Retail Mortgage Backed Securities (or RMBS)/Commercial Mortgage Backed Securities (or CMBS): 5%.
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. Both indices struggled this month, though now that the Maiden Lane auction is over, we should see some strength return. As yields get tight, more institutional investors and hedge funds are looking at this space. A lot of bad news is priced in and the potential for significant upside is also attracting them. It is still out of favor, but after the success of the Maiden Lane auctions, there should be more room for this sector to appreciate.
Editor's Note: For more from Peter Tchir, check out TF Market Advisors.