The foundation of the U.S. bond market, and the global market in general, is that bonds are less risky than stocks and that U.S. Treasury securities (bills, notes, and bonds) are "risk free."
But the times they are a changing and Treasurys may not be as, "risk free" as people think.
U.S. Treasurys are considered "risk free," because these fixed income instruments don't have any material credit risk; they’re backed by the full faith and credit of the U.S. government. Unlike a corporation, which can go bankrupt and default on its bonds, there's virtually no risk of the U.S. government not paying the principal and interest on its debt.
But default risk is not the only risk investors face. Risks such as: liquidity, geopolitical, and interest rate fluctuation can affect asset pricing too. In today’s fixed income market, we’re more concerned about these risks than default risk. According to JP Morgan, overall corporate leverage has increased by 60%, since pre-crisis levels, while credit quality has remained stable, as borrowers are more profitable and incur less interest expense burden. While the risk of broad-based corporate defaults has not yet increased, it should not be ignored.
Is the Market Mispricing Liquidity Risk?
Liquidity paints a different picture. Last month, the overnight repurchase, or repo, market experienced a liquidity event, which forced the Federal Reserve Bank to intervene. A repurchase agreement is a form of short-term borrowing where an investor sells (generally) government securities to a dealer (in this case) on an overnight basis, with a commitment to buy back the securities at a higher price. The dealer’s profit is an implicit interest rate known as the repo rate, a proxy for the overnight risk-free rate.
Why do we care? The repo market plays a crucial role in maintaining efficiency in financial market operations. It serves as a cost-effective short-term funding source for institutional participants. It helps promote liquidity and price discovery within secondary markets. The repo market is used to prevent settlement failures and the Fed uses it to facilitate open market operations. The liquidity event in the repo market sent shockwaves across markets.
Repo rates are typically small, lower than rates in unsecured markets because repos are secured by Treasurys. But in this instance, the repo rate surged above the unsecured lending rates. Someone offered 10 percent interest to purchase a, "risk free" U.S. Treasury yielding 2 percent.
Investor angst erupted. Why pay so much for short-term borrowing? Default risk hadn’t changed. Because the repo market froze since buyers and sellers weren’t coming together as they would in a liquid market.
In the wake of the event, Lorie Logan, senior vice-president at the New York Fed, told the Financial Times (FT) that officials were looking at why cash failed to move from banks’ accounts at the Fed into the repo market. Essentially, banks were not willing to lend Treasurys overnight.
In an interview with the FT, New York Fed president John Williams questioned the hesitance of the banks. “The thing we need to be focused on today is not so much the level of reserves [held at the Fed],” but rather “How does the market function?”
Enter rehypothecation, which is the practice by banks and brokers of using, for their own purposes, assets that have been posted as collateral by their clients.
Simply put, rehypothecation is like a daisy chain. The Fed estimates that for every $10,000 that an investor receives in collateral, 85% of it goes right back out the door and is used as collateral by someone else who is borrowing on it. As the collateral continues to flow through the system, the original collateral is used by more and more parties causing the daisy chain to grow and increasing the potential for illiquidity, at least by those using repo financing. This adds another level of risk to Treasurys in that people may think they own a Treasury, but they really don't.
In 2007, before the financial crisis, for every Treasury, there were three people who thought they owned it. This has been called the velocity of collateral. The velocity of collateral is "the ratio of total pledged collateral received by large banks, that is eligible to be reused, divided by the primary collateral," according to Manmohan Singh, a senior economist at the International Monetary Fund and the author of Collateral and Financial Plumbing. According to this notion the velocity of collateral was 3.0 in the pre-crisis era. Today, the velocity is 2.2, up from 1.8 in 2016. The greater the velocity of capital, the greater the potential impact on liquidity. Basically, if you don't really own the Treasury, it's certainly not a, "risk free" asset.
So, Treasury liquidity fluctuates, what’s the big deal? US Treasury implied volatility, which the MOVE index estimates, is the highest it’s been in over 3 years, but liquidity has remained tight. Given liquidity tends to move with volatility, it’s possible the demand for US Treasurys is overstating liquidity.
To correct the overstatement could require a dramatic price decrease. A halting of the recent adjustments, which we see likely, may lead to such a decline. It depends on how the FED delivers its message and whether its economic growth forecasts are accurate. Enter risk number two, geopolitical risk.
Source: Bloomberg Finance, October 29, 2019
Past performance does not guarantee future results. It is not possible to invest directly in an index.
Manufacturing Continues to Weaken
Globally, the manufacturing sector has been declining. While the non-manufacturing segment remains above 50, the US ISM Manufacturing index has dropped to 47.8 from the August 2018 reading of 60.8. (A reading below 50 implies a contractionary environment.)
We believe this is being driven by geo-politics; specifically, the current trade war and Brexit (the focus of our November article). Both events create tremendous uncertainty in the global economy. Still, from the vantage point of the labor market, the U.S. economy remains quite strong. At historically low levels, initial jobless claims counter the suggestion that the U.S. is entering a recessionary environment. We believe the low ISM Manufacturing reading, is more a function of business’ rethinking their production lines because of the recent trade disruption.
Signs of a slowing global economy include: China’s recent GDP growth of 6% year over year, its lowest growth rate since March 1992; a slowdown in both global manufacturing and U.S. consumer spending.
We expect the U.S. and China to make significant progress in their trade negotiations and think they both need to make a deal before the 2020 U.S. presidential election cycle.
Both liquidity risk and geopolitical risk present day-to-day challenges for fixed income managers who measure success based on total return, and where performance is calibrated against peers. Somewhat counterintuitively perhaps, these risks – not default -- are the ones that drive returns.
What Does It ALL Mean?
A key metric in pricing fixed income assets is the relative difference between the bond’s coupon and current (applicable) interest rate. It is the fluctuation in rates, whether driven by liquidity, geopolitics or migrating credit quality, that causes bond yields to reprice. And as a bond’s yield approaches zero, its price becomes more susceptible to changes in interest rates; its effective duration increases.
Using the corporate and Treasury components of the Bloomberg Barclays Aggregate Index, as a proxy for their overall universes, we see both exhibit historically high sensitivity to interest rate fluctuations. The modified adjusted duration, or effective duration, are at their highest levels since their inception. Small interest rate moves aren’t a big concern; it’s the big moves that get you. Now that global growth is slow, rates are persistently low or even negative throughout the world. Based on Fed communications and economic conditions, we feel lower rates aren’t necessary. They won’t help stop a trade war. The economy is not likely to enter a recession soon, and the Fed has diminished ammunition to fight a recession if one should arise. Rates, barring a trade war continuation, are more likely to increase than decrease.
Both in the US and globally, interest rate sensitivity is at historic highs. We have a yield starved investor base. In an uncertain world, especially an uncertain world where a liquidity crisis was narrowly averted through central bank intervention to fix a broken repo market, we feel that investors need to be open to the possibility that risk may not be priced appropriately in today’s markets. And Treasurys, especially when considering the potential price impact of a rising rate environment, may not be as risk free as the textbooks imply. We continue to focus on select corporate and structured credits as attractive alternatives to Treasurys.
Thank you for your time,
Aware Asset Management