US bond market environment, October 2012

This is the quarterly letter sent by Strategy Asset Managers, LLC, a bond management firm, posted with permission from my friend and mentor, Denis Jamison.

Today’s post sketches out the current situation.  Tomorrow’s wil give Mr. Jamison’s investment conclusions.

a market of bonds

It’s an old saying on Wall Street–this isn’t a stock market but a market of stocks.  In other words, individual stocks can rise or fall regardless of the general direction of the market.  The same can now be said of the fixed income market.  formerly, the direction of interest rates dictated returns across most segments of the bond market.  If Treasuries called the tune and the rest of the fixed income market danced along–some a little slower or faster–but they were all moving to the same beat.

That’s now changed.

Policies implemented by the federal Reserve effectively have eliminated real yields for “riskless” securities like US Treasury bonds.  (By riskless, I mean credit risk–that is, the risk of not getting paid at maturity.  T-Bonds still have plenty of market risk.)  Without government bond yields calling the tune, all sorts of other factors are determining returns in various segments of the fixed income market.

The markets are now being driven by monetary policy designed to:

(1)  keep interest rates at zero for short-term, low-risk investment-like savings accounts and US Treasury bills and notes,

(2)  narrow the yield spread between “safe” investments like US Treasuries ans riskier investments like corporate bonds, and

(3) lower the return spread between fixed income assets and securities with no maturity–like common stocks.

In fact, the Federal Reserve would really like investors to go out and spend their money on real goods and services.  It has stated that zero interest rates are here to stay until the economy has fully recovered–that means much lower unemployment and much stronger economic growth.  Chairman Bernanke, unfortunately, doesn’t have a crystal ball and isn’t telling us when he thinks that will happen.  At the moment, however, he plans no change in interest rate policy through 2014.  Of course, he has pushed out the probable end date of his quantitative easing program before and is likely to do it again.  Market pundits have started referring to the Federal Reserve’s monetary policy as QE unlimited.

When the bank is playing…

…you just keep dancing.  We have just entered the third phase of the Federal Reserve quantitative easing.  in the wake of the 2008 financial collapse.  Essentially, “quantitative easing” means that the Federal Reserve will buy financial assets from banks and put cash in their–the bankers’–hands.  The hope is that, somehow, this money will filter through the system and the banks will loan that money to you and you will buy a house or a car or anything.

Why doesn’t the Federal Reserve just lower interest rates and make the loans cheaper?  Well, interest rates are already at zero so they need to do something else.  Since the banks are stuffed with money, will they loan the money to you?  No, because you don’t have a stellar credit history and your house is under water.  They refuse to take credit risk because they face political and regulatory retribution if they suffer any losses.

Has the quantitative easing program improved the economy?  Not yet, but it has certainly been a windfall for the financial markets.  The S&P market index is up 115% off the 2009 lows and every time it seems to be losing steam, we get another QE program.

Is all this going to end badly?  Probably, yes, but in the meantime don’t fight the Fed, don’t fight the tape and keep dancing.

The quantitative easing programs are having one clear impact–a massive increase in the Federal Reserve’s balance sheet.  The Federal Reserve was created in 1913 through a bill sponsored by two legislators, Carter Glass and Parker Willis.  Mr. Glass later went on to co-sponsor a bill that prohibited commercial banks from being securities firms.  (Interestingly, that 1933 piece of legislation was struck down during the Clinton administration.  Some say the repeal was a root cause of the 2008-2009 financial collapse.) The Federal reserve’s mandate was to provide liquidity to the banking system in times of crisis and to gradually expand the money supply to support non-inflationary economic growth.

Until 2008, the Federal Reserve provided that liquidity to the banking system by gradually expanding its assets through the purchase of government bonds from the banks.  That has changed.  Federal Reserve assets grew from $890 billion in June 2008 to $2.8 trillion most recently.  This is the result of asset purchases made by the Federal Reserve through its various QE programs.  Government bonds account for $1.6 trillion of those assets.  Another $800 billion are mortgage-backed securities and the Fed plans to add about $60 billion a month to that pile.  Unfortunately, the Federal Reserve’s capital base hasn’t kept up with the asset growth.  Now, $55 billion in capital supports those $2.8 trillion in assets–a leverage ratio of 50:1!

So, the Federal Reserve has done an excellent job of reducing leverage in the banking system through the purchase of all those assets and, as an additional benefit, helped keep government borrowing costs low.  But it has transferred a large portion of private sector bank leverage to its own balance sheet.  Any percentage change in the price of the assets on its balance sheet will be reflected fifty-fold as percentage change in the Fed’s capital.

In the movie”It’s a Wonderful Life,” the banker,George Bailey, was lucky enough to have an angel when his depositors make a run on the bank.  I hope Mr. Bernanke has an angel on his side if interest rates ever rise.


More tomorrow.

fixed income prospects for 2012

My first boss on Wall Street, who taught me securities analysis in the late 1970s, switched to the fixed income arena in the early 1980s.  He runs Jamison and McCarthy Investment Advisors LLC, which manages money for institutions and high net worth individuals.  His 4Q11 letter to clients gives a polished industry veteran’s view of the current global economic situation and its implications for bonds.  He’s relatively bearish.

The analysis is very worthwhile reading.  It’s long enough, however, that I’m going to publish it in three posts, all sans charts.  Here’s the first, an outline of the current bond situation:

Is it time to get off the bus?

2011 was a remarkable year.  The bond market encored its 2008 performance as investors flocked to the safety and liquidity of US Treasury securities.  We brought back the same actors–inept central bankers, anxious politicians, sketchy borrowers and frightened investors.  The accents were a little different–more European–but the plot was the same–a financial system supposedly on the verge of collapse.  And the ending for investors was also the same–the frugal, risk averse bond buyer won the prize in the final scene.  The prize in this case was a whopping 30% return from investing in long term US Treasury bonds.  And this came on top of a good showing in 2010–a 9.4% return for US Treasury bonds.  But as all moviegoers know–the third installment in a series is usually a dud.

We don’t think the numbers add up for another bond market rally in 2012.  Last year’s increase in bond prices lowered yields sharply.  For example, the Barclay’s Long-Term US Treasury Index closed the year with an effective yield to maturity of just 2.7%.  This compares with 4.1% a year ago.  The smaller yield means a smaller cushion against any price decline.  Meanwhile, the mathematics of bonds is such that lower yields equal greater price risk for any given change in interest rates.  The measure of risk is called duration and the duration of the Barclay’s Long-Term US Treasury Bond Index on December 31st was 16.2 compared with 13.9 for a similar basket of bonds a year earlier.  Now, investors should expect that a one percentage point change in interest rates would cause a 16.2% change in the price of the bonds, a very nice gain if interest rates for twenty year government bonds fall to 1.7%.  If, however, the yield of such securities rises to just 3.7%–a level 50 basis points below the average of the last five years–get ready to book a 13.5% negative total return (yield plus price change).  Of course, the returns from bonds with shorter maturities would be less damaged.  Nonetheless, there would be plenty of red ink for all.

If you think current bond market returns aren’t very generous, you’re right.  The sub-2% ten year government bond yields produced during the final quarter of 2011 were the lowest on record.  In fact, they were lower than the rate of inflation.  This has rarely occurred.   This occurred during the inflation tsunami of the Seventies, and again, briefly, in 2005 and early 2008 when oil prices spiked.

The bond market has reached these low levels because of:

(1)  fears of a European banking crisis,

(2) the free money policies of the Federal Reserve, and

(3) modest non-government domestic credit demands.

The impact of these factors is being amplified by hedge fund “risk-on, risk-off” trading that pushes short term money between various capital markets.  If any of the three legs supporting the bond market cracks in the months ahead, a substantial interest rate increase is in the cards.

That’s it for today.  More analysis tomorrow and Wednesday.