No News Was Good News
One of the basic tenets of our investment process is that market pricing overreacts. Investors get too comfortable, too nervous, or they extrapolate short-term trends far into the future, causing valuations to overshoot. In 2015, a number of real, fundamental stresses appeared in the global economy, spooking an already nervous credit market. During the first few weeks of 2016, that pessimism intensified. Oil fell below $30, credit spread widening accelerated, and the High Yield market swooned. In only six weeks, credit instruments had doubled their entire negative excess returns to U.S. Treasuries for all of 2015. Bond markets were full of talk of recession and default.
Then it reversed, abruptly, in the middle of February:
Investment Grade excess returns made a full round trip, and High Yield is now ahead for the year. So did something momentous happen to turn markets around? To us, the more important thing is what didn’t happen. As we wrote in our last Strategy Update (“The Absence of Bad News Can Be Good News”):
Investors should be wary of this level of pessimism: when a lot of bad news is built into prices, all it takes for risk assets to earn the hefty premiums they have accrued is the absence of more bad news.
Even as markets blew off their remaining pessimism, economic data rolled in that was, if not much stronger, persistently not bad, and consistent with the slow growth we’ve seen for the last seven year:
- slow but steady GDP growth,
- continued growth in consumer disposable income,
- continued growth in labor force employment, earnings, and hours worked, and
- impressive growth in durables purchases, consumer credit, and job openings.
In the absence of more bad news, investors began to take U.S. recession risk off the table.
The tenacity of the U.S. economy was only one of the catalysts for the turnaround. In January the Chinese Government committed itself to 6.5%-7% growth targets (read: stimulus), the European Central Bank (“ECB”) expanded their Quantitative Easing (QE) program to European corporate bonds, and the price of oil stabilized. These developments all addressed risks that had been driving spreads wider. The ECB action also made the U.S. bond market relatively more attractive for investors.
Through it all, we continued to add and extend credit exposure to portfolios at a measured pace, just as we did the last time spreads reached these attractive levels in 2011. Why a measured pace? Why not jump in with every dollar? Because hasty transactions are expensive in this less liquid bond market, and there are remaining credit uncertainties, primarily overseas. Persistent job growth and – finally! – consistent growth in labor force participation over the past several months, strike us as important credit fundamentals. News outside of the U.S. consists of policy actions and a bounce in the notoriously fickle oil market. Let’s discuss a few areas of concern:
Energy remains risky, even if prices are firming
While we’ve seen a 50% increase in the price of oil from the bottom, and a truly massive 400 basis point decrease in energy spreads, the Energy industry is still enduring extremely low prices, widespread credit deterioration, and a wave of defaults, with more to come. Oil production levels have been resistant to lower prices and a lack of capital investment, global production levels won’t fall in a material way in the next quarter or two, and Saudi Arabia and Iran seem unlikely to end their production war. The ratings agencies have essentially declared this a changed world for the Energy and Oil Field Services industries, revising their methodologies and downgrading nearly every company in the sector.
There will also be continued secondary fallout. Mass defaults of oil companies in the U.S. will pose a significant challenge for the pipeline industry. A recent court case has troubling implications for the durability of pipeline contracts in the event of customer bankruptcy (historically, these contracts have tended to survive bankruptcy and travel to the surviving entity). It’s possible we are looking at a secular change in the pipeline industry’s risk profile. That is why the only three names we have picked up in this sector have a high degree of government (U.S. or Canada) regulated contracts, which mutualize the contract obligations, mitigating the threat of mass counterparty defaults.
The Energy exploration, services, and now transportation industries still face unusually severe conditions. However, we believe North American electric generation bonds and loans present a valuation opportunity. While low fuel prices lead to low “spark spreads”, or decreasing generation margins, we don’t expect a huge fall-off in demand.
Furthermore, with an increasingly vigorous push away from coal and towards ‘sustainable’ forms of generation, companies that are well-positioned in fuel mix and geography enjoy particularly resilient demand, or even outright subsidies. Natural gas is a favored fuel in many locations, due to its lower CO2 emissions. For coal, on the other hand, the prognosis is very grim indeed. Weakness persists in spreads for generation companies, but this seems a good place to find durable credits.
As we noted in our prior Strategy Update, given the boom-and-bust investment cycle in energy, further volatility is quite likely. Overall, given the dramatic changes underway, the valuation opportunities in energy come with significant and novel uncertainties. We are planning accordingly.
Low and negative yields have unintended consequences; pose a challenge for financial issuers and U.S. MBS
Over a third of developed bond markets now have negative yields. In Japan and Germany, negative sovereign yields extend to around 10 years. In Sweden and Ireland they run to 4-5 years. In Italy, yields are negative out to 3 years, and in Portugal they are zero under one year maturities. Thinking back to 2011, who among us would have predicted this?
Negative yields signal an absurd preference for cash tomorrow over cash today. Rational investors would only buy negative yield bonds with the expectation of capital gains from further rate decreases. Without repeated easing, or recession and deflation, the capital gains vanish and total returns turn negative rapidly. Investing for gains in negative-yield bonds is the proverbial “picking up nickels in front of a steamroller.” We won’t touch them.
Central bankers are attempting to perfectly calibrate the speed of that steamroller. On both sides of the Atlantic, it seems that the Central Banks have become part of the market, as opposed to above it. On January 10, Mario Draghi cited volatility in financial and commodities markets as a reason to reconsider the ECB’s policy stance. On March 29, Janet Yellen introduced “global market conditions” as an important variable in Fed policy deliberations. Whether the economy deflates or investors bail out in anticipation of higher rates, “global market conditions” can deteriorate, demanding another Central Bank response which can drive rates even lower. How, exactly, is a central banker supposed to extract herself from this dilemma?
Any large-scale government policy will have unintended consequences, but especially so when operating without a map. The last several quarters have brought rapid and contradictory rate movements around the globe. We don’t expect it to stop. That constitutes another reason, over and above the thin spreads, to steer clear of U.S. Agency mortgage-backed securities. They perform better in less volatile, more range-bound interest-rate environments.
Negative rates over the long term can also interrupt credit and risk intermediation in the bank lending and insurance channels. Banks are also facing questions about their Energy and Emerging Market exposure and have suffered from lower expectations of Fed rate hikes. Therefore, it isn’t surprising that bank spreads also spiked ominously in the middle of the quarter, and concerns about the new bank capital instruments took center stage. Deutsche Bank Series A Preferred stock dipped rapidly, amidst speculation that the bank would not be permitted to make some of its preferred dividend payments. The resulting dive in prices brought swift reassurances from European bank regulators, another example of the ECB’s dilemma discussed above.
We are not fans of the new bank preferred instruments, let alone contingent capital notes (“CoCos”). These new junior capital instruments have been designed explicitly to function as ‘bail-in’ capital to save banks, not steady income for debt investors. The newer Preferreds are often perpetual in maturity, and have “non-cumulative” dividends, meaning that multiple payments can be missed and never recouped. Both the newer Preferreds and CoCos have mandatory conversion features, becoming equity precisely when the contractual protections of debt are most desirable. It isn’t surprising that their prices are volatile – they have the duration and low return of a very long debt instrument combined with the downside risk of equity. The equity of strong banks is a much better long-term investment proposition. For eligible fixed income accounts, we own only a few of the pre-crisis legacy Trust Preferred instruments. These instruments have hard maturities and cumulative dividend obligations. They’ve been paying us a consistent 6%, but are likely to be called in the next year or two.
We were pleased to take advantage of the weakness in bank credit to purchase quite a few senior bank bonds, particularly for our more credit-constrained accounts. We remain up in quality, buying solid U.S. banks, and only the most well-capitalized and most sovereign-protected of Northern European, Australian, and Canadian institutions.
Property and Casualty (P&C) companies are in an increasingly tight spot, with low investment rates and a ‘soft’ market in underwriting (i.e. compensation for risk is poor due to an abundance of capital). Of the few good values in the sector, our focus is on companies that can make underwriting profits without higher interest rates and/or are excellent investors, well-positioned for a variety of outcomes.
A rally isn’t necessarily the end of the cycle – consider 2000-03
In 2009 and 2012, the end-of-cycle rallies were triggered by very large and clear Federal Reserve and ECB actions, intended to take systemic risk off the table. From 2000-02, the credit markets absorbed a series of sector-specific problems (dot-coms, telecom, accounting fraud, consumer lending losses) as well as slow growth. As a result, the full range of the spread cycle unfolded over a long period of time.
The National Bureau of Economic Research (NBER) declared March-November 2001 a recession (in November 2001) due to two non-consecutive quarters of negative economic growth. Even though November 2001 was declared the trough, slow growth characterized the entire 2000-02 period. We note that the current, tepid GDP trajectory (1.2%) is not far from this mild, or “growth” recession.
Market prices will make their own unique path, rather than repeat the past. The fundamental backdrop for this credit cycle, however, is certainly more like 2002 than 2011. These above-average spreads will seem attractive at cycle end, but given all the global sources of uncertainty, there’s no particular catalyst (e.g. rapid recovery or overwhelming central bank action) to drive them back to their tights right away. Furthermore, as we have noted in recent Strategy Updates, values are not distributed evenly across sectors, so less cyclical bonds have provided fewer opportunities.
In sum, investment grade credit offers solid long-term value, but economic growth seems increasingly hard to come by and there are significant remaining uncertainties in the credit landscape. It is better to move deliberately, rather than in huge jumps, and not to let “fear of missing out” drive decisions.
CMBS look very attractive
One of our larger exposures is commercial real estate-related credit. We own a handful of bonds issued by specialized Real Estate Investment Trusts (REITs), and we have purchased several Commercial Mortgage-Backed Securities (“CMBS”) at increasingly attractive yields.
CMBS widened dramatically in the last few months. As you can see in the chart below, this sector has come late to the rally, and has yet to contribute much to performance. Nonetheless, the yields we have locked in are much higher than non-energy corporate yields. Typically we invest in high profile properties with very strong institutional owners, and with equity or enhancement that, in our analysis, allows the underlying properties to refinance at 65% loan-to-value even in the case of decreased rents and a severe recession. Most of the properties in our portfolios are reporting increases in re-leasing revenues, the malls are reporting higher foot traffic and rents, and hotels and office buildings are at high levels of occupancy. So not only do we see wide spreads and strong structures, but also the underlying property performance is still improving. Ratings discipline, while easing, remains strict relative to the pre-crisis era.
Over the past 5 months, CMBS investors seemed to anticipate a U.S. recession at the same time a large amount of issuance hit the market. This created a substantial opportunity. All in all, CMBS look like one area of spread opportunity that is less susceptible to some of the global uncertainties described above. Outside of the triple-A rating category, CMBS spreads tend to be almost twice as volatile as corporate spreads. The ride can be bumpy, but we view impairment risk as very low in our CMBS bonds. We are heavily invested for clients who allow CMBS.
Increasingly, this is a two-tier market. The traditional “conduit” form of CMBS, containing dozens of different loans, loan types, and borrowers, remains highly volatile and trades at very high spreads. Many of our holdings are so-called “SASB” issuance, which stands for “single-asset, single-borrower”. These have been less volatile, and performed better, than traditional conduits. In fact, SASB issuance is siphoning off the best loans that used to anchor large conduits. SASB bonds are much more amenable to deeper fundamental analysis, whereas conduits were built for statistical underwriting. SASB deserve, and are increasingly getting, a market reception closer to Investment Grade Corporates. BBH CMBS Specialist Vaidas Nutautas has recently authored a piece on this growing part of the CMBS market (“Rise of the Single-Asset, Single-Borrower Market”, March 2016) which we invite you to download from our website.
Asset-Backed Securities remain steady, with opportunities in consumer credit
Unlike CMBS, Asset-Backed Securities (ABS) have been far less volatile than Corporate debt. Most sectors of this expanding market produced small excess returns even as Corporate credit lagged severely last year. Spreads widened in the last few months, probably due to liquidity stresses in bond markets.
There were a few pockets of weakness in ABS, notably subprime auto ABS, consumer credit, and containers. In the case of subprime auto, losses tend to rise in the first quarter, as borrowers get overextended through the holidays. This has happened each of the last four years, and each time it has prompted speculation of a bubble. Current losses are still below the baseline level we assume in this class of collateral, let alone the much higher levels at which we stress-test our purchases. Meanwhile, our existing auto loan portfolio, with an average life of about one year, is building credit enhancement as it seasons, becoming less vulnerable to negative trends as it ages. Our latest collateral run (in early March) puts the average of our entire subprime auto ABS credit support at 43%, meaning losses would have to reach a 43% annual rate before our position takes any loss. Within that average, the lowest estimated ‘breakeven’ loss level on any single bond is 22%.
Container ABS have widened recently in response to lower trade volumes. Here we have made no new purchases since January of 2015, more for valuation reasons, than for credit concerns.
Finally, fears of recession in the U.S., combined with a slew of new issuers, caused a sell-off in consumer ABS. We have been saying “no” to a lot more ABS issuance than before. The outsized returns that the best auto and consumer lenders have achieved have attracted new competition. Newer lenders have entered the market, reaching down in credit quality, and longer in term. We’ve seen this not only in auto loans, but in direct (often internet-based or ‘marketplace’) lending to individuals and businesses. Some of these lenders are even securitizing without retaining any of the underlying risk, which we automatically reject. On the whole, the bond market is meeting these new entrants with a healthy dose of price resistance, which is good to see, but it has affected the sector generally. We’ve become pickier, due to increased competition from Corporate valuations as well as these credit trends, but selective investing in ABS remains the best way to earn strong yield in shorter maturities.
Job and income growth are the most important determinants of consumer credit and property performance. Our structures are built to withstand tough times, but given the sturdiness of job growth, workforce growth, and income growth, there is a good chance of upside surprises here. There would be even more upside with a little inflation. Speaking of which…
Inflation emerges – will it see its own shadow?
Even as negative real rates extend well out into the yield curve, the Treasury Inflation-Protected Securities Bond (“TIPS”) Market, emerging like the groundhog from its winter hibernation, has been signaling higher near-term inflation. While the Nominal 3-Year U.S. Treasury Yield rallied 20 basis points in the first quarter, inflation implied by the TIPS yield increased by almost 60 basis points. A recovery in oil and gas prices likely drove this big change. With unemployment hovering around 5%, and workforce participation turning positive since September of last year, markets seem ready to consider inflation again, or at least, given the ECB’s dilemma discussed above, the increased risk of higher inflation.
In addition to fundamental factors, technical factors are also strong. The U.S. Treasury took actions to increase T-Bill issuance and reduced net TIPS supply by 45%. Issuance increases focused on the long end. Furthermore, inflows to TIPS ETFs have grown by 11%.
When breakevens were low over the last six months we took the opportunity to convert account U.S. Treasury holdings to TIPS, a decision that benefited accounts in the quarter.
There’s a lot to be pleased about this quarter. To us it appears to be a market that presents good valuation opportunities yet is sensitive to news. We proceed at a deliberate pace, adding attractive yields while purchasing credits we think can be durable in a variety of circumstances. That, after all, is the best way to generate strong long-term excess returns in the fixed income market.
Andrew P. Hofer
Neil Hohmann, PhD