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Weekly Fixed Income ETF Overview and Outlook

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A Meaningful Opportunity
We see the trading of this past week as an opportunity to add significant risk across the board.
We have seen a broad sell off in treasuries.  That has dragged down the more rate sensitive products with it, primarily investment grade bonds and municipal bonds.  Then you have seen the most credit sensitive products rally, with high yield, leveraged loans and EM outperforming.
There are several reasons we see a disconnect but let’s run through the important events that have shaped the market.

Janet Yellen came out with guns blazing on Monday.  She re-iterated her support for QE.  She was going out of her way to back up what Bernanke had said the prior week.  While he focused on talking down ever selling bonds, she talked about the ongoing need to buy bonds in the meantime.

While I feel their policies are distorting decision making, both in the markets, and more and more in the real economy, it had the intended effect of creating a “risk on” mood.  Treasuries sold off on the back of her dovish talk.  This is where I see the opportunity.
The Fed will be in buying $1 billion or more of longer dated bonds on the 11th, 12th, and 13th.  I think once again people have gotten ahead of themselves in selling the bonds.  The Fed isn’t just concerned about getting money to slosh around the system, they do focus on yields.  They will be very careful not to let yields on corporate bonds or mortgages to creep much higher and to do that, they have to cap the move on the treasuries.

The bank stress test from yesterday had some interesting bits of information.  It could be random, or may be an insight into what the Fed thinks it can achieve.
In the “adverse case” the Fed has stocks doubling in price by the end of the scenario.  That is coupled with a real GDP estimate of 4% and a nominal GDP estimate of 4.6%.  Yet, in the scenario the 10 year remains at 2.2% at its peak.  Does the Fed really belief it can get a stock market to double with GDP growth above 4% and keep the 10 year yield at only 2.2%?

Maybe the scenario wasn’t that well thought out, but of all the complaints about the Fed, being stupid and disorganized are not high amongst them.  The other interesting factor was that they barely had mortgage rates budging during the adverse scenario.  The BBB corporate bond yield used for the stress test moves much more than the mortgage rate.  Again, insight into their plans and intentions?  Will they just keep buying?

Italy calmed down and bonds backed to almost pre-election levels.  That is good, but I think we forget that European politics moves more slowly than our own.  So often we have felt the winds of change but it didn’t have an immediate impact on the market.  The knee jerk reaction to the election seemed overdone (though we weren’t as aggressive on that as we should have been), but now the complacency seems dangerous.

Italy still has the potential to cause problems.  Very little is going well in Spain.  It might be getting worse less fast but that is about as good as it gets.
What was more interesting was the Q&A about Outright Monetary Transactions (OMT) at the ECB press conference.
I was shocked that many people didn’t seem to know that OMT is just a plan.  It is an okay plan, but that is all it is.  Nothing has been formalized.  I am not 100% sure that the ECB has confirmed it has the authority, but it doesn’t seem like they have drafted anything more thorough than their original brief press releases.

The key takeaway is that Italy or Spain would have to ask for the ECB to engage in OMT.  Unlike here, where the Fed can just do what they want (or so it seems), the ECB is constrained.  They managed to push OMT through by saying countries would have to come to some form of agreement on “conditionality” and “monitoring” with the IMF’s involvement.
If it wasn’t for ego on one side (Spain and Italy) and stubbornness on the other side (Germany) than these countries would have already agreed to OMT backstop programs.  The IMF would have given them relatively easy terms and the ECB would be ready to step in if necessary.
But that would be far too simple.  Instead we run the risk that the crisis deteriorates, the government has no clear mandate, and that is when they need OMT.  So rather than putting programs in place during quiet periods, they will wait until the crisis is brewing again.  That leaves so many potential risks
  • In Italy would any leader have the mandate to negotiate the “conditionality”
  • Would Germany get cold feet and push the IMF to demand strict terms
  • Will other countries get nervous and push back so that any support from the ECB and the ESM (European Stability Mechanism) is senior and not pari-passu
I am not horrified of these risks, but think they are not being priced in, and given how surprised I was that people seemed to have very incorrect perceptions about the status of OMT, I think there is more downside risk than is priced in.
Eventually Italy and Spain will be the place to invest (and they had a great week) I just think the timing is too soon and the risk of some problem is higher than continued rally.

Fixed Income ETF’s are Portfolios of Bonds
In some ways it seems silly to send this out, yet many track the ETF’s, particularly the high yield ones as though they are equities.  We go through the mechanics and some examples in JNK is a Dirty Price.  Bonds have their own return characteristics, with high yield being the most difficult to analyze, but it is important to focus on the
Sentiment versus Reality, or What is Priced In

IG CDS is our favorite position.  Away from that bank credit seems very attractive, and we are looking for treasuries to bounce with next week’s Fed activity.
On the negative side, the PIIGS are the most concerning.  So little is priced in versus some realistic downside scenarios.
We like credit spreads much better than equities at these prices.

Treasuries: Now Is the Time
The sell-off on Monday continued throughout the week.  Once again many are confident that treasuries are going to be sold as part of a “great rotation”.   Maybe, but the float is small, the Fed is buying some next week, and we have traded well since the post NFP sell-off.
I like treasuries here, but also think TIPs are worth a look.

Credit Performed Well
It is a shame that there isn’t a good “spread” product as investment grade spreads, particularly CDS did very well last week.  LQD as a yield product just couldn’t keep up.
If you can do CDS, then that is the best opportunity, away from that, you need to be careful.  LQD doesn’t have enough spread to interest me here and I think as a pure rate or duration trade, treasuries are better.

BKLN is just overdone.  The leveraged loan market isn’t going down, but it isn’t going up from here.  Has been a nice stable carry trade, but think we will start seeing reduced coupons and the love affair or fascination will slow down.  Nothing really bad about it, but I wouldn’t be buying now as the new flood of investors have to learn to digest
  • LIBOR Floors
  • Flex Pricing
  • Weak or No Call Protection
  • Weaker covenants and credit terms
For leveraged loans in particular, it seems a mutual fund is still the best.  You don’t really need the liquidity of an ETF, it is a longer term horizon, and benefitting from the manager’s credit skills is important.  Possibly even more important is access to the manager’s ability to source loans.  Relationships are an important part of getting loans in a market as strong as this.  The best, and only cheap way to source loans is through the new issue market, and the ETF just doesn’t have that ability.

I would be getting more comfortable with high yield, but the price action got ahead of itself.  The premium is a bit of a concern, especially at such low yields.  The market effectively “ate back” the dividend in two days.  I can’t help but think some people saw the price lower and decided with “risk on” they should be buying, but that isn’t how the underlying bond portfolio works.

Similar to leveraged loans, with the “beta” gone, looking for specific funds or managers with different portfolio construction can make high yield investing more attractive than the ETF.

For those who lament these products as purely “retail” it is changing rapidly.  There is growing institutional interest and it looks like a block of 4.8 million JNK shares traded Friday afternoon.

This is it.  I like municipal bonds.  They are hard to source but offer some yield.  I am more comfortable that they will be able to outperform treasuries here.  I like the bonds from a credit standpoint and their existing ownership base.

EM Bonds – A Nice Change
EM, which had been struggling did well.  The USD denominated funds finished unchanged (which is good given the move in treasuries) and the local currency fund had a nice run.
Chinese data didn’t look strong to me, so I am holding off.  Also with Europe not fully engaging in currency wars and some risk that people start pricing in a slowdown of QE, local currency debt might not have the same upside.  I want to see more of a real reversal before dipping toe back into EM.

Dividend Stocks and Income Stocks
We have been looking at PFF.  I would like it, but haven’t dug into the portfolio enough.  We think bank credit spreads are attractive.  Again, if you can do CDS, sell the bank CDS.   PFF might be an interesting way to play it, but we haven’t finished combing through the portfolio yet.
There has been a “stigma” attached to investing in bank credits yet somehow not with their stocks.  It is possible that the Fed Stress Test results from yesterday can get some momentum going for bank credit spreads.   I think they are in better shape than they have been in a long time and Dodd-Frank is better for creditors than shareholders.

Blue is JPM’s share price.  You can see that it hasn’t been this high since 2007.  The CDS on the other hand was much tighter in 2007 and was even tighter since the crisis.  That is the most attractive part of the credit market.

Fixed Income Allocations                     
The “Core” strategy is meant to have limited number of trades.  It would only be readjusted as longer term views change, or short term views become very large or very strong.

The core strategy has high duration risk and medium on the credit exposure.  
The “Traded Strategy” is meant to have more frequent rebalancing and to capture smaller moves in the market.

An aggressive position in rates here.
The “Aggressive Trading Strategy” is meant to be traded frequently and will expect to generate more from positioning than from yield.

The portfolio is aggressively positioned for duration and is looking for underperformance in high yield.
POSITION:  No positions in stocks mentioned.