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Weekly Fixed Income Report: Ignoring is Bliss

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FIXED INCOME
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Ignoring Is Bliss
The S&P 500 finally broke through the 2007 highs.  The Dow had achieved that a few weeks ago, and Nasdaq only has 55% more to go to reach it’s 2000 highs.

I won’t spend much time joining the celebration because it seems to have occurred while ignoring some very real issues.  For the first time in weeks, the economic data was not good at all:
  • Consumer confidence plummeted to 59.7 down from 69.6 and versus expectations of 67.5.  While I am hardly a fan of this being useful, it was interesting to see such a big drop, and it came out as same time as Richmond Fed Manufacturing index pulled back to 3 from 6.  Again, not another important data point, but worth noticing.
  • The New Home Sales missed.  They came in a 411,000 down from a downwardly revised 431,000.  Again, we all want the housing sector to recover, and Bernanke is doing all he can, but it doesn’t mean it will happen.  Wanting to believe something isn’t enough and that data is at least worth thinking about.
  • Pending home sales (reported as percentage change) were revised down to only 3.8% growth in January and actually declined by 0.4% in February.  The case for a strong rebound in housing is there, but the data isn’t being cooperative.
  • Q4 was revised up to 0.4% which was better than the original print of 0.1% but below expectations of 0.5% and consumption was lowered (from 2.1% to 1.8%) and the PCE was increased (from 0.9% to 1.0%) which is not a good combination.  Slightly higher inflation (and the PCE is the key inflation indicator for the Fed) and lower consumption is not healthy.
  • Initial jobless claims came in at 357,000 rather than 340,000 expected.  The positive spin was that it was government layoffs that impacted it and not the real world.  For those who lost government jobs, it probably felt like the real world.  This number is by no means bad, but on the other hand, it isn’t great and may be moving in the wrong direction.
  • Finally the Chicago Purchasing Manager index came in at 52.4, down from 56.8 and far below expectations of 56.5. These “diffusion” indices have a pull to 50 effect so I take it with a grain of salt, and 52.4 still signals growth, but not great growth and another sign of possible deceleration.
So the economic data certainly looks like it was ignored this week, but it isn’t just that.  Single stocks are too easy to miss certain stories or drivers, but Caterpillar (CAT) which should be doing well if the global economy was doing well has had weak guidance and is struggling, ditto Fedex (FDX), another bellwether.  JPMorgan (JPM) has also been sliding while much of the strength in equities recently has been from Utilities and Healthcare.  More things that if the market was in a bearish mood, we would get bombarded with daily, and for now are hearing relatively little about.  That can change quickly.

Speaking of Ignoring, What Happened in Europe this week?
The markets breathed a sigh of relief as banks re-opened in Cyprus without rioting.  I guess that is something to be excited about except for the following reasons:
  • Cyprus has electronic banking, and I don’t think a modern bank run occurs with people lining up to take out limited amounts from either an ATM or even from a teller where the withdrawals were also limited
  • There is rumbling that much of the “Russian Oligarch” money had already been pulled and that the hole is much bigger and rather than admitting they were wrong, the ECB is aggressively supporting the banks behind the scenes.  The idea makes sense because the negotiations took time and while I don’t know much about “Russian Oligarchs” I strongly suspect that they didn’t get that rich without having connections and being one step ahead of those out to get them.
  • Country after country took time to dispel the notion that there is now a new EU Bailout Template, when there actually is a template.  Normally when Europe goes to such lengths to deny something, especially something that seems obvious, they are usually lying.  This isn’t quite as strong as a signal as when the EU trots out the “speculators will lose their shirts” but it is something that investors should pay attention to.
While the broad market was calm about this, the credit markets were far less sanguine.



The SNR FIN CDS index, a CDS index based on senior unsecured risk to European banks got back to levels last seen just after OMT had been announced.  This is the 3rd leg higher this year, which started with Rajoy and Monte dei Paschi, moved into the Italian elections and has now moved to a broader issue.  Each of these legs has shown higher highs and the rebounds have been shorter and smaller.

In a world of central bank funding, global swap lines, bans on naked CDS, and any other of a number of programs designed to make it easy for banks to do well, and difficult for investors to spot signs of weakness, this one is decent.  It is a “hedge” index so tends to overestimate problems (many false positives), but this is at the heart of the current problem in Europe and is telling us to be very careful.
Separate from the banking crisis, Italy still has no effective government, which may become an issue, and the economic data in Europe this past week seemed bad, and even mighty Germany was hit.

Treasuries versus Stocks
Before digging into the different fixed income markets in more detail, I think the following chart is worth a quick look.  In spite of the “hype” that the S&P 500 hit new highs, and all this talk about the “great rotation” the S&P has barely beat the long bond since the middle of February.  Treasuries have actually outperformed the S&P 500 since the middle of March.



This is a good reminder that we don’t need a “rotation” to occur for stocks to do well and given the negativity about bond yields, versus the excitement about stocks, I think this chart will surprise many.  If you have time, you may want to read last week’s report, particularly the section on the yield curve, because as the Fed makes it abundantly clear, rates will remain low for a long time, and that anchors bonds, particularly 10 years and in.

Sentiment versus Reality, or What is Priced In



Bank credit spreads now look the most attractive.  The widening in JPM and others seems unwarranted and while Europe may have problems, the big US banks are well positioned.  That hit our radar screen as moving to most interesting.  IG CDS remains good, though we remain on sidelines there as the view that people held off buying protection until the roll seems to be playing out and Europe is still tricky.   Treasuries, which have performed well are a bit of a conundrum.  Given their recent move, it looks as though investors like them, but as far as I can tell this was much more about stop losses and begrudgingly buying than any real belief in their value.  As a whole, we shifted the “reality” back across the board on US assets as the data just wasn’t that good.

In Europe, we are once again seeing some “redenomination” risk being priced in with German 2 year yields going back to negative.  I think we have had an event that will push Europe to either create new currencies (or revert to old ones) or that we see a much more aggressive ECB, one that looks like what the Fed does and the BOJ says it will do.

In terms of hypocrisy, we have US high yield and leveraged loans in the danger zone, yet are currently recommending them.  I just don’t yet see much real downside in spite of seeing absolutely no upside.  Maybe that is how “coupon clipping” asset show up in our model.

ALL DATA IS FROM THURSDAY MARCH 21st To THURSDAY MARCH 28th.

Treasuries:
Another strong week for treasuries, though they sold off on Thursday and the equity market continued to take the fixed income ETF’s lower after the bond market had closed at 2pm.
Our favorite part of the curve remains the 10 year, because of Fed ownership, small float, high forward rates, the curve, and the fact that the mortgage market prices off of it.  Having said that, the 10 year note got to the lower end of our range 1.85% so it is time to be careful as we could see a pullback.
TIPs actually did well this week, finally.  For all of the “bond bubble” talk and fear of inflation, TIPS have done relatively poorly.  This week’s performance is interesting, but I am still dubious that we will see any real demand, especially as the latest economic data was unconvincing from the growth story perspective.



Another Mediocre Week For Credit
For the second week in a row, credit has lagged.  It hasn’t been particularly bad, but it hasn’t been great either.  Investment grade bonds were up in price, but saw a bit of spread widening.  That is consistent with the CDS market which saw bank CDS increase and corporate remain roughly unchanged.

High yield did okay.  Some new issues, and pretty stable flows.  The ETF’s are constrained on the upside due to the fact that these are bond portfolios and the pull to par effect is strong at these prices and yields.  High yield investors are struggling with what to do with all the longer dated, higher quality bonds, yielding in the 4.5% range.  To hedge rate risk or not?  It is a relatively new phenomena for the market to deal with.  We liked both of these for the “dividend” play.  As we described, the ETF’s should trade like a dirty price, but there has been a trend for investors to pay back up on dividend days and make for a profitable trade.  While disagreeing with the idea that investors should do that, we aren’t going to fight what seems an obvious mistake, because it is easy to see how and why investors make that mistake.

We will see how it goes, but we continue to see high yield as capped on the total return side.  While we don’t see much of a sell-off (more of a “coupon clipping” market) the lack of real liquidity is a bit of a concern, and the fact that so many funds seems to own the same bonds for “liquidity” reasons opens the potential to have a larger faster move than they would otherwise.

The leveraged loan market remains very interesting.  Paying a premium to own the ETF that owns loans that are callable with almost no upside seems dangerous.  Not as dangerous as buying FLOT which I don’t understand at all (LIBOR is not going up anytime soon).
The supply/demand issue in leveraged loans is getting worked out, but not necessarily for the better.  As CLO’s still scramble for paper, many of the attractive features of leveraged loans are being eroded:
  • LIBOR floors (where much of the CLO arb comes from) are decreasing and hearing of some now below 1%
  • Spreads continue to contract and ratings based resets are appearing
  • Covenants and collateral packages are weaker
There still seems to be limited downside, but if CLO equity isn’t attractive, the market could get a little weaker as dealers and potential managers get nervous about their warehouse facilities.



Muni’s
Muni’s moved a lot like corporate bonds this week.  A little better on the week, but not as strong as treasuries.  We continue to like the market as an improving economy should help most municipalities.  It would be better if Washington was out of the way so we could be certain that laws won’t be changed to the detriment of the market, which is why positions aren’t too aggressive.



EM BondsWARNING
While not as bad as last week, EM continues to struggle.  The local currency bonds did okay, but away from that, it was weak, and that was in spite of strength in treasuries.  So EM underperformed corporate bonds and munis once again.
 
Chinese stocks were also down and this relationship between EM bonds and Chinese stocks seems persistent.  We are working on a broader measure, or one that at least seems more directly tied, but we have noticed this for awhile, and price action to us warns that we aren’t done in weakness here yet.

The most interesting part of the week, was that Bernanke took the time to describe QE as being helpful for emerging market nations.  That our policy of QE is helpful to them.  As much as he may believe it, and it may even be right, I think this is a clear sign that behind the scenes there is pushback from Emerging Market Nations on our policies.  That the “currency wars” aren’t helping them and they are unhappy with QE in an economy with okay data.



Dividend Stocks and Income Stocks
PFF did well again.  We continue to like bank credit spreads in the U.S. relative to corporate but with the move in bank CDS would pull back from PFF for now.  We like the concept of these bonds, but the CDS market traded very poorly in financials last week, overdone in our view, but since PFF was up, it is good time to sell and see if there is a better opportunity to reload.  XLF is not something we would own here.  Lower volumes and lawsuit noise seem to be the order of the day and that will impact bank stocks more than their credit spreads. 

XLU did extremely well.  It was up 2.6% on the week.  That has been one sector of dividend stocks we have liked as we expand our coverage of dividend sectors.

Mortgage Reit’s like NLY did well again.  This sector had two distinct moves down last year.  One was after the mortgage purchase announcement by the Fed, and the other was fear of tax changes post election.  We have finally clawed back to levels that roughly correspond to pre-election prices.  Was the Fed intervention sell-off overdone?  I think so and I think there is some room to run, but a lot of the “easy” money has been made in these names now.

Fixed Income Allocations 
The “Managed Income” 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 goal is to provide good current income while protecting downside risk.



The Managed Income Strategy has high duration risk and medium on the credit exposure.   
We reduced exposure to longer term treasury again slightly and shifted it into municipal bonds.  For the first time we were tempted to add some high yield but have decided to wait until we see how the events in Europe play out next week.   On the leveraged loan side, it was tempting to cut the position again, but couldn’t bring ourselves to do it yet as the portfolio is already conservatively position.

The “Total Return Income Strategy” is meant to have more frequent rebalancing and to capture smaller moves in the market.   The trading is to be opportunistic to capture additional moves to the upside and also to be able to be more defensive at the expense of current income, with a goal of providing a greater total return than a less active portfolio.



A small shift from treasuries into munis.  For first time since late last year we have added back high yield.  This is purely an attempt to capture the dividend.  A pattern that we have seen and think we understand why it occurs, even though we disagree with it.
We have left the exposure to dividend stocks unchanged at 5% but are considering how to rebalance that as the move has been so strong, and even PFF, which we like, diverged too much from bank credit spreads

The “Total Return Enhanced Income Strategy” is meant to be traded frequently and will expect to generate more from positioning than from yield. Short positions will be used opportunistically.  The goal is to generate significantly higher after tax total returns from the fixed income markets than more passive strategies.



The portfolio is aggressively positioned for duration.
We have covered the high yield short ahead of the dividend.  Will add it back but think for a day or two that trade is one not to be on the wrong side of.  With covering the high yield short, we have left treasuries in as protection to the downside, and add munis and left TIPS.  Definitely the most aggressive positioning in some time.

If you are interested in learning more about a fixed income product from Peter Tchir, please contact us at support@minyanville.com
POSITION:  No positions in stocks mentioned.

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