Third Quarter Returns

At first glance, total returns through the third quarter would suggest a very good year for most sectors of the bond market. The YTD returns are 9.2% for the Treasury market and a whopping 23.4% for the 30-year bonds. Virtually all of those returns, however, were achieved in the first quarter when the full impact of the virus on the economy became evident. Since then the Treasury market has returned only 0.6% and the bond has returned -1.5%. Portfolio performance has been excellent only if Treasuries were sold at the end of the first quarter.

Corporates show the opposite pattern of returns–negative returns in the first quarter but goods returns since then. Investment grade returns are only 6.6% YTD, but 11.1% over the second and third quarters. For high yield, returns were steeply negative in QI but are 14.3% since then. Muni market returns have been less volatile–slightly negative in QI and a return of 3.9% since then.

TIPS have performed very well, with a modest 2% return QI and solid returns of 4.2% and 3.3% in Q2 and Q3. In the process, they have become expensive versus the nominals. Perhaps PMs recognized that fact in September, as TIPS recorded a return of -0.2% in the month. TIPS will continue to benefit from the inflation adjustment of close to 2%, but going forward, additional price gains are unlikely.

Price gains are probably unlikely in most other sectors in the quarters ahead. Treasury yields appear to have begun a very slow uptrend because the economy is growing and more Fed easing is unlikely. Corporate spreads have room to narrow some, but future returns will be primarily coupon income. Muni-to-Treasury yield ratios remain unusually generous, so the muni market could withstand an uptrend in Treasury yields. A blue wave on election day is expected to result in higher tax rates and, thus, boost the demand for munis. But, with yields already so low, any benefits might be limited. In the past, economic trends have been far more important to the muni market than tax law changes.

Investors who need portfolio income should heed the advice presented in the latest Barron’s. Look to leveraged funds such as REITS and closed end bond funds and/or high dividend equities. If the Fed intends to keep the fed funds rate near zero indefinitely, why not take on leverage? One should, however, be cautious when choosing REITS, as the outlook for commercial real estate is extremely uncertain.

Friedman Would Be Apoplectic

Back in the 1970s, Professor Milton Friedman of the University of Chicago was at the peak of his influence on the field of macroeconomics. He was the titular head of what was called the monetarist school of economic thought. That school held that growth of the money supply was the most reliable indicator of future inflation. And, indeed, rapid growth in M1 and M2 did precede a march to double-digit inflation during the second half of that decade. Rapid growth back then was annualized rates of 10-14%.

Over the past six months, those growth rates for M1 and M2 are 70% and 38%, respectively. Over the past 12 months, 40% and 23%, respectively. Such growth rates would, presumably, have driven Professor Friedman to call for the removal of all members of the FOMC.

But, the economy today is far different than in the 1970s. Recall that the explosion in the Fed’s balance sheet (QE) in response to the “great recession” of 2008-09 also prompted forecasts of rapid inflation. Those forecasts proved to be wrong because QE did not result in rapid growth in the money supply. Growth rates of M1 and M2 remained anemic because private sector borrowing had collapsed during and following the financial crisis. Without growth in bank lending, the Fed’s provision of a huge volume of bank reserves did not produce faster growth in the money supply.

In 2020, however, there has been a big increase in private-sector and federal government borrowing–as reported in the latest quarterly Fed report. And that has facilitated the explosion in M1 and M2.

But, will that explosion lead to a big jump in inflation, as the monetarist theory would suggest? Probably not. Almost all of the recent increase in private-sector borrowing has been business borrowing. Ordinarily, such borrowing would finance increases in production, inventories and expansion of plant and equipment. Those activities would eventually pressure labor and goods markets, driving up costs of labor, raw materials and support services. Before long, the inflation indices would start to become worrisome–as in the 1970s.

Today, however, almost all business borrowing is done to stave off bankruptcy or liquidation, not to expand output. Borrowing today is an attempt to avoid an even greater collapse in economic activity, not to finance an expansion of activity. If there is no sustained expansion in activity, there would not be pressures on labor and goods markets that would lead to broad-scale price increases. Until this recession ends, there is probably no link between money growth and inflation.

Inflation of asset prices, especially financial assets, is, in my view, a more legitimate concern. There is no question that bond prices are inflated to the point where most sectors of the bond market are invitations to lose money over the next 12 months. If the economy were to recover at a sustained moderate pace in 2021, the current levels of interest rates and bond yields would probably become unsustainable, despite the Fed’s promises of low rates forever. But this forecast is not based on expectations of a big jump in inflation. That is not a prerequisite to the return of more rational market conditions. Control over the pandemic and a consequent resumption of something close to a sustainable economic recovery would be sufficient.

Muni Carnage

I have been involved, one way or another, with the municipal market for four decades, and in that time I cannot recall carnage such as we have seen the past two weeks. Two weeks ago, the yield on the Bloomberg 10-year AAA GO benchmark was 0.80%. On Friday that yield was 2.88%. That translates into a price drop of almost 20 points. For 30-year GO bonds, the price decline is almost twice as great. And for many troubled revenue names, getting any bid has become difficult or impossible. For comparison, over the same period, the yield on the 10-year Treasury rose approximately 30 bps. The price declines on the top-quality munis have been as great as those on high yield corporate bonds.

There have been other periods of market meltdowns, but not like this in munis. In early February 1980, (remember Jimmy Carter?)the corporate bond market stopped trading and Treasury bond bid/offer spreads widened to as much as a point. In 2008, high yield corporate spreads reached 2000 bps (they are around 1000 bps now)and some short-term markets seized up. But even in those bad markets, munis tended to perform better than taxables. In the past two weeks they have performed much worse than comparable taxables.

Two factors appear to be responsible for this carnage. Fears of a prolonged, deep recession that would decimate revenues to state and local governments is one. But more important, in my view, is that portfolio managers had been posting such good returns these past two years, that they were more than fully invested, unprepared for even a modest selloff. Then, when they needed to raise cash to meet withdrawals, they confronted a market in which dealers are far less equipped to make good bids than they were before Dodd-Frank. A version of a perfect storm.

Even the Treasury market succumbed to this storm. There too, almost every participant was long, the shorts having been squeezed out in the prior weeks. Thus, when the prospect of a huge increase in Treasury borrowing prompted some selling, there were no natural buyers. And when equities get hit badly, high yield corporate spreads always widen significantly. So the current disarray in that market is not surprising.

So, what are we to do? At yields close to 3%, the 10-year AAA munis are priced as if the 10-year Treasury yield were above 3%. We are unlikely to see that Treasury yield anytime soon–perhaps not for a year or more. The Fed is going to keep the funds rate near zero well after the economy has begun to recover from this recession. At the risk of grabbing a falling knife, I would be buying munis at these yield levels. Better yet, buy a fund that is supported by a seasoned team of credit analysts. It is often a good idea to avoid stepping into a high yield market in disarray. This, however, is a market of solid credits now dominated by irrational selling. As Mr. Buffett is fond of saying, buy when there is blood in the streets. That is an apt description of the muni market today.

Double Trouble

Record low Treasury yields are rightly attracting lots of media and investor attention. Few have noted, however, that those low yields also imply record long durations. For example, the duration of the 30-year bond is now 23 years, not a great deal shorter than the duration of the 30-year STRIPS. In years past, the “rule of thumb” was that the duration of the bond was half the maturity or around 15 years. But that was when yields were in the 5-8% range, not 1-2%. A 23-year duration means that market yields need rise only 10 basis points over the next 12 months to produce a negative return on the 30-year bond for that holding period.

But, there is another, more ominous, potential problem for bonds–the flat yield curve. What will happen if or when the curve regains a positive slope? In past cycles, flat curves emerged after periods of Fed tightening that sent short-term rates sharply higher and bond yields somewhat higher. To 5-51/2% in 2006, for example. Those high rates and yields eventually led to recession, Fed easing, short-term rates falling more than bond yields and a steepening of the curve. Bond prices actually rose as the curve steepened.

That scenario is impossible today. If, in the months or years ahead, a positive slope emerges, it must involve a significant increase in bond yields and a significant decline in bond prices. And, with yields this low and durations this long, even a modest steepening would inflict big losses. An increase of only a percentage point in the long-bond YTM would push the price down by more than 20 points.

To be sure, with the focus now on the risk of a recession, curve steepening is not on investors’ radar. Nobody is talking about it. If, however, the economy avoids a recession and rebounds from a first-half slowdown, market participants will need to consider the risks presented by super-low yields and an untenable yield curve. We might even see the revival of a term we veteran bond people heard in the 1970s, i.e., bonds have become “certificates of confiscation”.

Phantom Returns

Bond market participants–investors and portfolio managers–are rightly pleased with the returns they have recorded in 2019. YTD returns such as 17% and 9% on 30- and 10-year Treasuries, 12% from investment grade and high yield corporates and 7% from municipals are impressive and gratifying. Those returns, however, do not automatically produce more money in the bank to investors. A sizeable portion could disappear in the months ahead–become phantom returns.

For example, of the 17% total return from the 30-year Treasury, only 2.5% is interest income that is actual cash to the investor. The remainder is from price appreciation. Converting that portion of return to real money requires selling the bonds. For the 10-year Treasury, 7% of the 9% return is price appreciation. Price appreciation accounts for approximately one-half of the YTD returns from municipals and high yield corporates, but 9% of the 12% return from investment grade corporates. Those are the returns that could be eroded if bond prices were to decline.

On the surface, one could make the same argument about equity returns in 2019. Those prices have also increased significantly since January 1. History suggests, however, that the long-run trajectory for equity prices is upward. That is not true for bond prices. As an example, over the past five years, virtually all the total return from the bond sectors mentioned above has been interest income. And, from these historically low yield levels, it would, in my view, be unrealistic to expect the 2019 price gains to persist indefinitely.

If, as now appears likely, the Fed is finished lowering the funds rate, the 2019 bond rally probably peaked in September-early October. If so, converting the price gains into cash would be advisable. That decision is made somewhat easier by the flat yield curves. Shifting from 10- or 30-year Treasuries to bills costs only 25 to 50 basis points of interest income.

Owners of individual municipal or corporate bonds should probably keep them. Selling them is much more difficult and costly that selling Treasuries. Investors who own those sectors in long-duration mutual funds or ETFs might consider shifting to shorter-duration funds.

For investors in high-yield corporate bond funds, credit risk is a greater concern than interest rate risk. If the consensus forecast of continued moderate economic growth in 2020 proves correct, default rates would be expected to remain relatively low. In that event, high yield returns would be expected to be close to average coupon income even if Treasury yields rise.

Selling one’s winners is never easy. A strong case can be made for not doing so in the equity market. With bonds, however, a significant portion of the “winnings” would disappear if market yields were to move only moderately higher in the months ahead. Then, much of the returns that look so impressive now would have been phantom returns.

ISMs and Recession

The bad news from the latest ISM indices is that growth in both the manufacturing and service sectors has slowed.  The good news is that these reports have displaced the yield curve as presumptive recession signals.  Until a few weeks ago, the inverted yield curve was cited almost hourly as a clear recession signal.  Now that the curve is no longer inverted, attention has shifted to the ISM data.

While the ISM indices have been better leading indicators than the yield curve, they have not been perfect (no one indicator ever is).  The recent declines are somewhat similar to the 2016 experience.  The manufacturing index fell from 59 in 2014 to 50 in late 2015 to 48 in January 2016.  The service sector index also declined over those months to a low of 51.8 in 2016.  By 2017, however, both indices had begun to rebound sharply.  The manufacturing index reached 60 by September 2017 and the service sector index reached 59.

Treasury yields fell as those indices weakened, as they have recently.  The yield on the 10-year note dropped from 2.40% in 2015 to 1.38% in early July, 2016.  The 30-year bond yield fell to 2.10% in July 2016.  By year-end 2016, however, those yields had increased more than 100 basis points.

While economic growth is not likely to rebound as strongly in 2019-20 as it did in 2016-17, there is a strong possibility that the ISM indices are bottoming now.  The new orders components have stopped declining, and other leading indicators such as initial claims, consumer confidence, auto sales and housing data are improving or are at very healthy levels.  And, if the ISM indices turn upward in the months ahead, Treasury yields will very likely do the same.

Total returns in September were examples of how the markets typically react when the economic data surprise on the upside.  The Treasury market posted a total return of -0.9%, led by a -3% return from the long bond.  TIPS returned -1.5%.  The muni market returned -0.7% and investment grade corporates returned -0.6%.  High yield corporates recorded a positive 3% return, but the weakest segment, the CCCs, had a zero return and a -2.3% return for the quarter.  While the BB credits have a YTD return of 13%, the CCCs YTD return is only 6.1%.  Just as in the stock market, investors appear to be shifting away from the riskiest issuers.

A final word about the jump in repo rates last month.  One factor was that dealers had taken down lots of the notes and bonds in the recent auctions and those positions had to be financed.  If this recent pattern of weaker investor demand confronting a heavy pace of Treasury borrowing were to persist, one would expect some downward pressure on prices now through year-end.  And, with yields again near all-time lows and durations very long, only modest yield increases produce significant negative returns.

Recession Bunk

The latest ISM manufacturing index reading of 49.1 has added to recession talk.  Recall, however, that the index must fall below 48 to signal a recession, and that it has often moved below 50 for a month or two and then rebounded.  That pattern probably reflects an inventory correction which, when completed, requires an acceleration in orders and production.

Other leading indicators such as initial unemployment claims, stock prices, housing starts and consumer confidence are not signaling recession.  Indeed, the drop in mortgage rates has produced a refi boom and is boosting housing activity.

But what of the inverted yield curve?  Isn’t that a recession signal?  Not when the cause of the inversion is a drop in rates!!!  Past prerecession inversions occurred when short-term rates were rising faster than bond yields.  That combination sent mortgage rates higher and pushed housing into recession.  In this instance, bond yields have declined and pulled down mortgage rates.  Someone needs to explain to me how lower rates would cause a recession.

If investors are forced to revise recession expectations, they would also need to revise rate expectations.  In that event, the very crowded long-bonds trades would get reversed and the consequent price action could be brutal.  The Wall Street Journal today described the duration extension trades mandated by the jump in refi activity and the lengthening duration of pension liabilities (remember learning about negative convexity?).  That helps explain the latest phase of the Treasury market rally, but it also identifies another source of selling if rates start to move higher.

The high yield market did not participate in this latest rally, so it is offering reasonable spreads to Treasuries.  That cannot be said about investment grade corporates or munis.  They are as expensive as Treasuries.  For example, the August rally produced total returns of 3.5% for Treasuries, 3.0% for IG corporates, 1.6% for municipals and only 0.4% for high yield corporates.  The high-yield to Treasury market spread is now around 430 bps, which is on the high side for a period of low default rates.  To be sure, if markets expected a recession, they would also expect an increase in default rates and wider high yield spreads.  If, however, those expectations are overdone, the current spreads are better than fair.

Patient Fed

A “patient” Fed has emboldened investors into risk on strategies thus far in 2019.  The question now is whether the markets have read too much into recent Fed statements.

Thanks to the Fed, the bond markets have totally recovered from the fourth quarter selloffs.  Year to date total returns are 8.9% for high yield and 5.6% for investment grade corporates.  In each market the weakest credit grades have performed best.  The Treasury market has underperformed, with a return of only 1.8%.  The muni market has recorded a YTD return of 3.4%, led by a 4.1% return for the BBB credits.  High yield munis have stopped outperforming, with a YTD return of 3.5%.

The yield on the corporate high yield index is now 6.15%, matching the June 2018 low and almost 200 bps less than in December.  The spread to Treasuries is now 375 bps, down from 540 bps early this year, but still above the 2018 low of 320 bps.  The typical range for that spread when defaults are low and the economic outlook is favorable is 350 to 450 bps.  Spreads of A rated 10-year corporates to Treasuries are now around 75 bps, near the bottom of the 70-90 bps spreads that are typical in a strong market.

Munis are even more expensive than corporates.  Ten-year AAA yields are now around 1.90%, down 100 bps since November, but still well above the 1.30% low seen in 2016.  But, the muni-Treasury yield ratios have collapsed this year.  Back in 2016, the 10-year AAA muni to 10-year Treasury yield ratio was 0.90.  Today it is 0.75.  Ratios are back to what we were used to seeing in the 1990s and earlier.  That might not mean munis have no value here, but it will be very hard for them to outperform Treasuries in the months ahead.

Equities have appreciated the Fed just as, if not more than bonds.  The S&P 500 Index is up 18.5% YTD!!  And the flood of IPOs is reminiscent of 1999-2000.

The FOMC statement yesterday was again interpreted to promise no rate increases ever again, and a cut or two is possible this year.  That apparently is not Chair Powell’s view.  He, and one would think the majority of the Committee, are comfortable with the pace of economic growth.  Even impressed by the latest GDP data.  If inflation were not below 2%, there would be renewed speculation of rate hikes.  Thus, I would not be adding to bond portfolios at these yields.  We need to be as patient as the Fed.


Bond market participants appear to be reassessing the odds of a Fed rate cut on 2019.  A rate cut became the consensus last quarter when Chair Powell shifted to a “patient” stance and global economic indicators turned softer.  Talk of a 2020 recession in the U.S. was abetted by a modest inversion of the Treasury curve.  That optimism on rates fostered a 3% first quarter return for the aggregate market index, a 2.9% return for the muni index and a 7.4% return for the high yield index.

Last week, however, the economic data were clearly not consistent with recession fears.  The two ISM indices were at solid growth levels and the new orders components were strong.  Sales of new cars and light trucks stayed above the 17 million annual rate in March.  Payroll employment was better than expected and unemployment stayed low, whether measured by initial claims or by the unemployment rate.  Thus, the fed funds futures markets no longer expects a rate cut this year.

Is, therefore, a rate increase a possibility?  A few sets of data cited by Randy Forsyth in Barron’s are interesting in that regard.  Since Powell restated the policy outlook in January, commodity prices have increased at an 85% annual rate, global equity prices are up at a 68% annual rate and financial conditions, as measured by the Chicago Fed, are the easiest since 1994.  Finally, refi activity is again surging.  Does this sound like an economy that needs lower rates?

The U.S. economy never grows at a steady pace, even in a sustained expansion.  There are always a quarter or two of slower GDP growth after several quarters of relatively rapid growth.  Indeed, the slower growth is welcome because it helps extend the expansion.  Today, with the economy at full employment, if GDP growth were to stay at 3% or better each quarter, a recession in 2020 would probably be more likely, not less likely.  Inflation would probably become more threatening and the Fed would probably need to abandon its “patient” policy stance.

If optimism about rate cuts got overdone last quarter, it follows that bonds got overbought.  Barron’s also quotes several bond portfolio mangers who are extending to longer maturities and weaker credits, including CCC corporates, in order to find yield.  This should be a warning that investors should now be “patient”.  Wait for better values.

Nowhere is patience warranted more than in the muni market.  Municipal-to-taxable yield ratios have returned to pre-crisis ranges.  The nice relative values of the past 10 years have been eroded by a combination of strong demand and limited net issuance.  But, the low yields are changing the supply outlook, especially for weaker names.  Those authorities have ramped up borrowing programs.  They would be irresponsible if they didn’t take advantage of this buying frenzy.  As this process proceeds, the weaker credits will account for a larger share of the tax-exempt market indices.  Thus, investors might want to think twice before purchasing a muni index fund.  Sound credit research is likely to prove very valuable in the months ahead, as will conservative duration strategies.



Dump The Dots

Members of the Fed’s Open Market Committee must regret having agreed to provide the dot chart estimates of future fed funds rates.  Those charts are doing more harm than good.

The charts stemmed from the Bernanke/Yellen hypothesis that providing more guidance about the rate outlook would make monetary policy more effective.  Hence, the charts showing what each member thinks will be the appropriate setting for the funds rate in the future.  While Fed officials argue that these are not rate projections, the markets correctly regard them as just that.  Common sense suggests that if one puts on paper a future path for rates, those are projections.

The goal was to shape expectations of the direction of policy and thereby allow markets and the economy to adjust in an orderly manner.  Apparently, it never occurred to the FOMC academics that markets are prone to overreacting to pronouncements from the Fed.  That is what is happening, and that forces Chair Powell and other officials to try to downplay the significance of the tenor of the dot charts.

Prior to the dot charts, market participants were very good, but not perfect, at predicting the direction of Fed policy.  Shifts in those predictions were far less disruptive than shifts in the dot charts.  Predictions from Fed officials have a much greater market impact, despite the fact that Fed forecasts have been no more accurate than private-sector forecasts.  Perhaps because the Fed’s projections are thought to be self-fulfilling.

Experience has shown, however, that the dot chart forecasts are not very prescient.  They have changed dramatically in response to unanticipated shifts in the economic data, and those changes have been disruptive–as in November-December.  It appears that the primary impact of this experiment in “Fed guidance” has been to focus too much attention on the admittedly flawed rate forecasts.  There are indications that FOMC members are frustrated by, but not sure how to improve this state of affairs.  Perhaps they should simply abandon the effort.