Fixed income market perspectives
- Hi, I'm Kevin Barr, head of SEI's Investment Management Unit. The stock market is getting a lot of attention these days as the coronavirus and the oil price war better share prices. In an environment of extreme volatility in the stock market, it's easy to forget about the bond market. With the US having roughly $30 trillion in stocks and 40 trillion in bonds, the bond market is significantly larger than the stock market. Globally, there's more than 100 trillion dollars in the bond market. With that in mind, I've asked bill Lawrence, our CIO of Traditional Strategies to join me today. Thank you for joining me today, Bill. Let's start by getting your perspective on what's going on in the fixed income marketplace.
- Hey, good morning Kevin. As it's been exhilarating, if nothing else, but I would say there's been three significant characteristics of fixed income that have occurred over the last several weeks. First of all, the Treasury yield curve has steepen through the course of these events aided by easing by the Central Bank and intermediate yields have fallen as well. Secondly, break even inflation rates have dropped by about a percent to about point six percent or so based on the tenure tips market. This is significant because that is the primary focus of Federal Reserve Policy right now is addressing the risk of deflation as it has been for most of the post financial crisis period. And finally, yield spreads in the non government sectors have widened dramatically. This is I think, where the most serious problems in fixed income have occurred, so you almost have a schizo frantic market where treasuries and high quality instruments are performing extremely well. But the riskier asset classes, structured products, including agency mortgages, and corporate bonds, and municipal bonds have underperformed fairly significantly.
- There's been a lot of talk about liquidity. And this crisis is a little bit different than maybe what we've seen in the past. What would you characterize the liquidity environment today compared to past crisis that we've seen?
- Okay, so first of all, I think the fact that yield spreads have widened as much as they had is very significant to note that is largely a function of very poor liquidity in both a corporate bond market and the municipal bond market. This is where we're actually believe ultimately the tables being set for some very good opportunities. When we contrast this with what we saw, say in the global financial crisis, it's a little bit different. The lack of liquidity is the same, but maybe the causes are a little bit different. I think when you think about the implications for the coronavirus is having on economic conditions. And I also want to acknowledge the importance of a collapse in oil prices as well. Underlying fundamentals have deteriorated, but when you look at where yield spreads are, what's being priced in around default rates is far in excess of reasonable expectations, so that's creating a liquidity premium in the markets that can be captured. Now looking back versus 2008, the cause of this as a different. One very important silver lining today is that commercial banking system is far healthier. That a lot of it has to do with the regulatory environment that was put in place, so banks are better capitalized. They have limitations on doing stock buybacks and dividend payments, this is all good for the strength of their balance sheet. Now, having said that, part of the regulatory rules that were put in place, the Volcker Rule in particular, is limiting bank's ability to kick commit capital to make markets. In today's market right now, banks are acting as agent. In other words, they'll match buyers and sellers, but they're not committing balance sheet to commit bonds and that's a challenge for the marketplace. So when there are sellers, you're seeing a widening of bid ask spreads and ultimately a widening of yield spreads.
- Bill, you mentioned inflation. Can you actually touch base on what's going on with FED Policy and the impacts on inflation?
- Yeah, so I talked about how breakeven inflation rates in the tips market have been falling. And that's very consistent with what you'd expect with collapsing oil prices and concerns about economic contraction. Most of the post crisis period, the FED has been struggling to get the inflation rate up. The objective is to get two percent or even slightly higher, and now we're faced with challenges of greater risk of even deflation in the global economic system. So the FED is clearly a recent policies about not only lowering the FED funds rate to effectively zero, but also re implementing quantitative easing and growing its balance sheet. Again, this is all targeted at addressing the risk of deflation, very important actions by the Federal Reserve. One concern is maybe they've used all their traditional monetary policy firepower, but I expect the FED will be using other unconventional tools as well. It wouldn't surprise me at some point that they use the balance sheet to acquire corporate or even municipal bonds, they may need an act of Congress to assist with that. The FED has put in place lines for the commercial paper market, very important to make sure the plumbing of the short term markets is working and in effect, we've been encouraged by the results we've seen in the last couple of days in the short term market.
- Bill, with all the uncertainty out there, what is it doing to our portfolios?
- Oh, Kevin, it's been kind of a mixed bag, candidly, our alpha generation has been a little bit challenged, that has come from our investment grade portfolios going into this situation, we were largely positioned with shorter durations, relative to benchmarks. It's a little bit different from where we were last year, but the fallen rates that occurred earlier this year, managers worked a shortened duration that's both in the US and what I'll call core Europe where government interest rates are negative right now. So that detract a little bit from relative return. One bit of good news in our investment grade portfolios is pre crisis here, we were actually working to become more neutrally weighted, and we had taking a lot of risk out of our corporate bond exposure. So that served us pretty well over the course of the last month or so and given us some dry powder now to take advantage of the opportunities that are cropping up. The structured products sector has also been in a little bit of a challenge. We've been a little bit overweight agency mortgages, with rates coming down, they're now being challenged by faster pre payments, which mortgage backed securities tend to not have a negative response to. And in the non agency sector that would be asset backed securities like credit cards and automobiles, or even commercial mortgage backs, which we thought were securities that would be well positioned for a more challenging economic environment. We have overweight there, we really like the structures and exposures we have, but in the flight to quality, we've still seen some underperformance there. So those are some things that detracted from relative return. One piece of good news from a relative performance point of view, is our high yield portfolio which has been underweight energy and in some sectors up in capital structure. So bank loans are senior in the capital structure and have liens on corporate assets, they're outperforming unsecured debt and the high yield market. So that's been an alpha generator for us in the high yield market. Emerging market we debt we've had a little bit of challenge. Currently, with some exposures in Mexican Peso and Russian ruble, which with the collapse in energy prices have underperformed. When you think about an easing FED, that is usually something that is very good for emerging market currencies. So we think ultimately, as we work our way through, there'll be some very good opportunities and local currency emerging market, energy related currencies are gonna be one exception to that.
- Low liquidity, lack of certainty in the marketplace, it seems like selection is going to be critical going forward for all marketplaces. Can you touch base on how our portfolios are positioned to take advantage of good security selection?
- Yeah, security selection, I think in fixed income right now when you talk about these liquidity challenged markets, security selection is when that can really come to the fore, I think the great opportunity for active management right now, if you're an investor who does not need liquidity and you can get paid to provide liquidity that is as close to a free lunch in the capital markets as you can find. And security selection is where we're gonna get that alpha. I think it is fair and we would have to acknowledge there are sectors of the market that are gonna be fundamentally challenged. So the energy patch in the corporate bond market, there's gonna be anything related to Travel and leisure will be challenged. And those are sectors, maybe certain sectors of the retail markets as well. Our managers are going to be doing security selection work to pick the best bonds, higher quality segments that are less cyclical in nature, there will be some excellent opportunities. And I think that idea applies to the municipal bond market as well, where again, I think, essential service bonds, like water and sewer, that are suffering in a liquidity crisis are offering an excellent opportunity for an active manager to take advantage of.
- How are managers trying to go ahead and upgrade the portfolios with higher quality assets?
- Yeah, so as we've surveyed our managers I'd say there is not the trend that they've worked to upgrade portfolio. In fact, that's the work they were doing before we came into this. Yield spreads are now earning valuations look rich, they had de risk some of the corporate exposures in particular, now the thinking is okay, we have some dry powder where do we put that work and when do we put that work? My observation is every manager almost is talking about doing that. I've not seen a lot of action taken yet. I think managers are working to preserve the liquidity in their portfolios first to meet liquidity calls, but they're starting to look at when and what they want to buy.
- Bill, thank you.
- Thanks, Kevin.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company.
Investing involves risk including possible loss of principal. . Bonds and bond funds will decrease in value as interest rates rise. High yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.
Diversification may not protect against market risk. There can be no assurance the goals will be met.