GW&K QUARTERLY INVESTMENT REVIEW 1Q16
By Harold G. Kotler, CFA Chief Executive Officer, Chief Investment Officer
Is it possible that the majority of investors in fixed income instruments do not yet realize that their income has been dropping steadily during these last ten years? Do bondholders still believe they are earning 4%, 5% or even 6% interest on highly-rated bonds? Really? At the end of the first quarter, U.S. Treasury bonds maturing in 10 years yielded 1.77% while three-month Treasury bills yielded 0.20%. The highest quality tax-exempt bonds yielded 1.70% maturing in 10 years and less than 0.45% in 3 months. The only bonds that yield 6% or more are high yield corporates.
So why do so many investors believe they are getting 4%, 5% or 6% yields on their money? Because almost all bonds are currently priced above 100 cents on the dollar. These "premium" securities give the illusion of higher yields because when the coupon is divided by the bond's price, the result is often well above 3%. But the critical word here is premium. Most bonds have fixed coupons that exceed current interest rates, which drive the prices higher. In some cases, bonds are issued with a higher coupon rate at a corresponding premium value.
Either way, without getting too technical, a perception is created that the bond throws off more income than is actually the case. Why? Because a portion of that "income" is not income but a return of principal, i.e. your own money. In plain English, the premium on the bond's price will steadily decline to 100 because all bonds mature at par. The longer the maturity, the slower the drop, but make no mistake: the perceived return is not the actual return. Many investment statements show only the "current yield" - coupons divided by market value. That inflates expected return. The current yield needs to be reduced by the amortization of the bond premium between the date of the statement and the maturity or call date to arrive at the yield to maturity or yield to call. These calculations are much closer to the actual return expected over the life of the bonds.
Why am I spending so much time on this explanation? Because I fear that too many will wake up and realize they cannot afford their lifestyle. And reaching for yield by investing in lowquality assets is not a prudent alternative.
Exacerbating this dilemma is the U.S. government's requirement that money market funds have enough liquidity to meet withdrawal demands during a crisis without breaking the $1 price. While that sounds like good policy, in order to meet those standards mutual funds will need to hold a disproportionate amount of Treasury bills in their portfolios. By October of this year, the demand for short-term government instruments will rise, driving Treasury bill rates even lower. It is not inconceivable that they could go negative.
The reality of lower interest rates needs to be one of the primary drivers of asset allocation models. It should also inform business decisions and liquidity events. For much of my 50-year career, it was so basic to look at "present value analysis," the discipline of calculating the cost of capital discounted over years. But as interest rates approach 0% or even negative yields, present value analysis becomes irrelevant.
Understanding the real value of existing assets is critical in deciding how to invest. There will be pressure to find alternative investments able to generate safe, decent returns. Real estate with dependable cash flow will become increasingly more valuable, as will stocks with healthy dividends. Intermediate corporate and tax-exempt bonds will provide some protection. In this environment, however, a decent return may only be generated by accepting the necessity of price volatility. Volatility is a far better alternative than capital liquidation. If investors are forced to spend down principal because income falls short of their goals and volatility fears keep them from diversifying into other asset classes, then a spend-down is inevitable and self-fulfilling. The more they spend down the less they have to invest, which will further increase the asset liquidation. However, if an investor accepts volatility, then the cycle can work in the opposite direction. Yes, assets will decline. Markets do go down and up, but volatility is not capital erosion certainty and may even result in an enhancement of capital.
Simply put-a wealthy person with $10 million does not want to live on $100,000 a year. So whether you're worth $100 million, $10 million or $1 million, the unfortunate message is to accept some volatility so that you can enjoy a return that will help you maintain your lifestyle.
In the end, do we bet on the American way of life or not? There is much to worry about, but that is not anything new. The economy seems to be at a point of cyclical maturity and nearterm growth will be slower than in the earlier part of the cycle. But that should not dissuade us from investing. It just means we need to be more deliberate and patient. Opportunity still exists here and around the world, so accept volatility in order to enjoy the benefits that continue to exist.
FIRST QUARTER 2016 MARKET OVERVIEW
- Back to Top -
MUNICIPAL BOND STRATEGIES
Municipal bonds posted solid returns in the first quarter despite lagging a much stronger rally in Treasuries. Munis continued to benefit from a combination of low new issue supply and heavy seasonal demand, the same technical dynamics that led to stellar performance in the second half of 2015. But with relative valuations already elevated coming into the year, there was a limit to how far munis would advance, even with the Treasury market on fire. As tax-free rates began to approach all-time nominal lows, the market pushed back with retail investors unwilling to chase paltry absolute yields while institutional traders seemed more intent on taking profits. The result was a welcome blend of stable performance accompanied by relative value ratios that were restored to attractive levels.
The year began with a massive global flight to quality as concerns over a slowdown in China and sliding oil prices drove the dollar higher, sent stocks into correction territory and fueled speculation of a recession. By mid-February, the yield on the 10-year Treasury had plunged over 60 basis points to a four-year low while the futures market was betting that the Fed would not be able to raise rates at any point this year. But amid all the gloom, the U.S. economy proved resilient. Stronger than expected reports on GDP, manufacturing and consumer spending eased fears of a downturn. Oil rebounded off its lows on speculation of coordinated global production cuts, which in turn alleviated pressure on banks exposed to the energy sector. Employment continued to firm and by quarter's end, both oil prices and the major equity indexes had recouped their losses. Interest rates, however, stayed relatively steady, with the yield on the 10-year Treasury finishing March at 1.77%, down 50 basis points for the first quarter.
The more subdued reaction from bonds stemmed from the March FOMC meeting, when the Fed signaled a meaningful shift in their policy guidance. With central banks in Europe and Japan aggressively adding stimulus and pushing overseas rates into negative territory, the Fed seemed less willing to work in the other direction. Without meaningfully altering its outlook on the economy, the Fed scaled back the forecast of rate hikes for 2016 to two from four and placed more emphasis on global developments in deciding the future course of policy. This means that even on those days when economic releases beat expectations, we shouldn't expect to see a meaningful rise in rates, as the reaction function of the Fed has changed for now. This new reality kept interest rates from rising toward the levels at which they began the year.
The shifting narrative underlying the Treasury market had broad implications for municipal bonds. In the early weeks of the year, municipals fully participated in the broader fixed income rally but the combination of low rates and rich ratios made them particularly vulnerable to a global rate selloff. Instead, municipal bonds significantly underperformed what turned out to be a powerful rally, followed by only a modest pullback. One concern for investors moving forward is that tax-exempt rates remain at historically low levels, as the yield on the 10-year muni closed the quarter at 1.70%, down 23 basis points from year end. The good news is that municipals became much cheaper compared to Treasuries. And with the growing amount of government debt overseas yielding less than zero, municipal bonds should be considered a relative bargain among high-quality, fixed income alternatives.
Over the first few weeks of the year, municipals benefited from the global safe-haven trade and the strong technical tailwinds that pushed 10-year tax-exempt yields to a three-year low. We sold aggressively into a market that was starved for paper, our typical response when valuations look stretched. We mostly targeted maturities inside ten years, lowering duration and harvesting gains in a part of the curve that had performed particularly well over the prior six months.
In late February and into March, municipal yields bounced sharply off their lows, underperforming the Treasury market by a wide margin. We took the opportunity to lock in higher rates as supply picked up and demand moved sideways. As importantly, the risk-return profile improved significantly with the muni/Treasury ratio topping 100% for much of March. While yields fell into the month-end close, relative value remained compelling. We will continue to reinvest as we see opportunities.
TAXABLE BOND STRATEGIES
Fixed income credit markets had an exceptionally volatile start to the year, but ended the first quarter largely unchanged. Investor sentiment during the first six weeks was dominated by concerns over a global recession, falling corporate profits, and excessive amounts of emerging market and corporate debt. Oil touched a 13-year low, the yield curve flattened to its lowest level in nearly ten years, and corporate bond spreads reached multi-year highs. But just as suddenly as risk markets sold off in the first half, they rallied into the end of the quarter. Oil rebounded sharply from its bottom amid expectations of a falling surplus, the labor market showed further signs of strengthening, and accommodative actions from central banks around the world renewed investor optimism.
Every major sector of the taxable bond market had positive performance during the quarter, with the Barclays Aggregate Bond Index returning 3.03%. A strong bid for safety and dovish commentary from the Fed pushed rates down across the curve, driving a 3.20% return for Treasuries, the best quarter for the sector in more than four years.
Investment grade corporate bonds experienced a particularly wild ride but ended the quarter as one of the best performing segments of the taxable market, returning 3.97%, led by the lower-quality and more cyclical BBB space (4.13%). The high yield market also experienced a strong quarter, posting a 3.35% return after rallying back from a deficit of -5.16% through February 11. Crude oil was the primary reason for both the decline and the subsequent rebound in high yield. Mortgage-backed securities were a relative laggard due to their shorter duration, returning 1.98%, while taxable municipals returned 5.16%, benefiting from their longer duration.
Though the volatility that characterized January and February largely subsided in March, investors nevertheless remain highly sensitive to the potential for further shocks. Evidence of this risk aversion is clear: Treasury rates remain close to their all-time lows, gold had its best quarterly performance in 30 years, and haven currencies like the Japanese yen and Swiss franc continue to trade near multi-year highs. The Fed responded to investor worries by lowering their forecast for future rate hikes, moving them closer to both market expectations and the comparatively easy policies of central banks around the world. In light of this revision, and considering the low inflation, moderate growth environment, we expect interest rates, particularly intermediate and long rates, to remain subdued. Our Strategies have slightly longer durations than their respective benchmarks given our continued aversion to the short end and preference for intermediate maturities. We believe the belly of the curve offers the most attractive carry and roll for the interest rate risk being assumed.
Despite lingering fundamental concerns, the technical backdrop for corporate bonds improved meaningfully in the first quarter. The European Central Bank's decision to begin buying investment grade corporate bonds has driven a shift in new issuance from the U.S. to Europe, slowing what had been a record-setting pace of origination in the U.S. and relieving some of the pressure that such abundant supply had placed on spreads. Meanwhile, in the high yield market, a combination of record inflows and a 70% decline in new issue volume helped tighten spreads almost 200 basis points from their February wides.
Though volatility receded toward the close of the quarter, low rates and elevated spreads reflect lingering caution among investors. To be sure, high quality issuers continue to enjoy access to credit and corporate defaults, away from the commodity space, are likely to remain below their historical averages. But the potential for a global recession, a massive uptick in energy defaults, or any number of "tail-risk" events could quickly usher in the return of volatility. With this in mind, we have little or no exposure to commodity prices across our Strategies. We remain overweight investment grade corporates because we expect them to outperform Treasuries in a moderate-growth environment. We are neutral high yield given increasingly bifurcated valuations and an uncertain technical outlook. And we remain biased toward higher premium mortgage-backed securities that should offer positive excess returns in the part of the curve most susceptible to higher rates.
The equity market ended the quarter with rather flat performance but it was a wild three months for investors. The quarter started with a very serious correction, with stocks trading down in double-digits through February 11. Several issues stoked fears of a global economic slowdown: energy and commodity prices continued to spiral downward, U.S. economic data was uninspiring, the dollar's strength continued unabated, and data from China and other emerging markets continued to disappoint. Fed comments suggesting rates might rise prior to the economy achieving sustainable growth only reinforced Firmthe fears. In addition, political tensions from most every corner of the globe further heightened investors' risk aversion. And then things changed. Year-end earnings reports and economic prospects were not as bad as feared, the Fed eased off its hawkish comments, the dollar weakened, commodities strengthened, and China stabilized. The weakness in the first half of the quarter was offset by double-digit gains in the second half, placing us on March 31 close to where we began the year.
The S&P 500 Index of large cap stocks advanced 1.35% for the quarter while the small cap Russell 2000 Index declined -1.52%. The combination of lower interest rates and a better economic growth outlook drove a rather curious combination of strong sectors that included both defensive names as well as more economically sensitive sectors.
It seems we write about the market's roller coaster ride almost every quarter, reflecting the mixed signals out there and suggesting the global economy remains rather fragile. On the negative side, sluggish global growth and the strong dollar have impacted our export-driven industrial companies and hurt reported profits of corporations with international exposure. China, which for years bolstered economic growth around the globe, continues to grow at a slower pace. Emerging markets continue to suffer from weak commodity prices, corruption and political mismanagement. Even oil's price increase from $26 to near $40 a barrel will do little to help those countries so dependent on oil. Geopolitical issues from Russia to Iran to the Middle East to North Korea, along with global terrorism, have made corporations, consumers and investors uncertain. And the market dislikes uncertainty.
While these issues have kept growth muted, they have also kept inflation at bay. This, in turn, has kept monetary policies in Europe quite accommodative. Even the Fed has backed off on its slightly hawkish tone. Thus we expect a continuation of this low inflation and low interest rate environment, creating a positive backdrop for equities.
Domestic economic trends are not as bad as they seem on the surface. Job creation remains solid, and the unemployment rate sits at just 5%. We could argue about underemployment or the quality of the jobs, but employers are unable to fill their more technologically demanding job openings, suggesting the issue is one of skills and training, not of job availability. Consumer confidence remains solid, and the favorable impact of lower energy prices on consumer spending has only just begun. The ISM Services Index remains in expansion territory, and even the ISM Manufacturing Index took a surprising turn into expansionary territory.
Looking at financial indicators, the tightening of high yield bond spreads, the firming of commodity prices and an improving trend in corporate earnings expectations all bode well for equities. Relative to interest rates (e.g. 10-year Treasuries are selling below a 2% yield), equities continue to look quite attractive. While corporate earnings have indeed declined over the past 18 months, it appears the trend has finally bottomed, with a return to growth expected for the remainder of the year. We would expect stocks to move higher over time, in tandem with improving earnings. Lastly, corporations still look to support stock prices with share repurchases and higher dividend payments.
While we are feeling more confident in the domestic market and economic outlook, we accept the fact that our strength is not in macroeconomics, but in identifying well managed companies that are leaders in their field, can gain market share regardless of economic outlook, and can put up consistent and sustainable growth over time. We will try to take advantage of dips in the market to add to quality companies at good prices, and to maintain solid relative performance versus the market and our peers over time.