I don’t know if the market is just damned drunk on low interest rates or hung over. But, it still hasn't come to grips with: “Why keep interest rates so low when it doesn’t seem to affect growth or inflation?"
I'll tell you why. Bond investors are addicted to low interest rates.
An addiction is having an intense focus on doing something over and over, even though you know it's going to cause problems. This sums up what the bond market is going through right now.
Investors can't seem to grasp how the economy can thrive if the 10-year U.S. Treasury's yield hits 3% (or any other rate materially different from the current level), even though lower rates have not spurred economic growth. Many fear, including the Federal Reserve (Fed), that the economy can't sustain higher rates. This fear was a big reason why rates were driven lower during the Fed’s recent mid-cycle adjustment. I think the bond market's view is incorrect. Low rates are not the panacea. Low rates may have prevented a recession, but they haven’t juiced the economy.
Spreads Continue to Tighten
It's hard to say the market is trading on fundamentals. We're flooded with debt. It's even harder to envision a world where the economy is worse, that rates are as low as they are, and trading spreads continue to tighten. Spread tightening is a sign that one worries less about liquidity or default risk, because everything's working great in the economy. However, if everything's great, why are interest rates so low? The answer is strong demand keeps rates low because risk-free assets are not paying enough nominal income.
With other countries posting negative rates, it may look like the U.S. market is fairly, or even attractively, valued. However, from a historical standpoint, today's rates are very low. Corporate spreads continue to tighten and are historically tight relative to the last 30 to 40 years. It looks even worse
when looking at the average spread, which has gone down, relative to effective duration, which has gone up. We still prefer the attractiveness of corporate debt to Treasuries.
In the current tight market environment, investors start to justify the price they're paying. That's because investors want the debt and are going to buy it regardless of yield. So, they justify the purchase to themselves and keep buying riskier debt. But, they should want wider spreads for the risk that they're taking for longer durations. Doesn't this sound like the lead up to the mortgage meltdown?
The three most important things in managing a fixed-income portfolio right now are active management, active management and active management.
Over leveraging leads to problems
We believe all this debt poses potential problems down the road. However, it would take a catalyst, such as an economic slowdown, to expose those problems.
One problem is that any company today can raise capital by issuing new debt. This means weak companies, that in a normal business cycle would go bankrupt or out of business, can now issue new debt and people will snap it up. The system doesn't have a chance to cleanse itself. When the catalyst hits, it will be the weaker companies that fail.
One can make the argument that the interest burden companies take on has fallen. Interest burden is the relative cost of carrying debt. But, that assumes that the market and economic environment stay the same.
Currently, there is incredible demand for this massive amount of debt. But if we experience an economic slowdown, revenues will fall. As companies' ability to pay off the debt is affected, the debt becomes harder to maintain. At that point, investors will start saying, "I don't want to buy this new paper because I don't think I’m getting enough downside protection." The result will be shrinking demand, higher spreads and lower bond prices.
My biggest concern is that if a recession occurs, revenues drop through the floor, which will hit operating margins faster than cash flow is able to pay off the debt. If operating margins fall too fast,
suddenly that interest burden, which wasn’t a problem, becomes a problem. Let's not forget, the 2008 fiscal crisis was caused by extending too much leverage.
If, as most believe, the Goldilocks scenario holds -- not too hot and not too cold -- then this will probably work itself out. But remember, the fairy tale ended with the bears eating Goldilocks.
Now is the time for active management
We're getting to the point where active management and bond selection will become even more important. Investors won't be able buy an index fund tracking the benchmark, the Bloomberg Barclays Aggregate Bond Index, better known as the Agg, and keep winning. This is because when weak companies issue a lot of debt, they become over-represented in the index. Which means every fund tracking the index owns these weak issues. We are always mindful of this risk in managing our exposures to any given company and sector.
Here's how we're preparing for when demand slows
Evaluating liquidity and default risk is what we do; buying blind doesn’t work in the fixed-income market. Currently, we continue to underweight our exposure to Treasurys, as we don’t see a flight to liquidity in the market, which would drive rates lower. We expect the short end of the yield curve to remain stable, but rates will rise at the long end, steepening the curve. The economic environment doesn’t support the requirements the Fed needs to begin tightening monetary policy.
If rates don’t move much, investors might as well be in corporate bonds. Everyone wants extra income, because they're not getting it from Treasurys. So, they hold their nose and buy BBB-rated bond issues (Triple Bs). But, not all debt is equal. Some A-rated issues (Single As) and active management provide tremendous value in this situation.
On average, we think the BB-rated bond space (Double Bs) is overbid and overvalued. Double Bs are high-yielding, non-investment-grade bonds. There are options in high yield, but today we prefer investment grade. On average, investment-grade bonds offer a better value compared with speculative-grade bonds. And we want the ability to get out before we get trampled in the stampede to the exits. It’s not the first drop that gets you; it’s the second one.
Thank you for your time,
John E. Kaprich, CFA
Aware Asset Management
Investing involves risk, including the loss of principal.
Funds that are actively managed do not seek to replicate the performance of a specified index and therefore may have higher portfolio turnover and trading costs than index-based funds.