“You can’t understate the significance of the strategic implications of last month’s policy announcement and subsequent market reaction.” So says Jeffrey Rosenberg, managing director and chief fixed income investment strategist at BlackRock in New York.
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| Ben Bernanke, Fed chairman |
“For the last five years global financial markets have operated under the assumption that the Fed would provide consistent and ever increasing amounts of monetary accommodation. Risk-free interest rates are the base upon which investment portfolios are built, and now that these are moving up from zero, its as big as it gets in terms of strategic impact.” With US rates and investment-grade credit offering little in terms of exciting returns over the past few years, investors had reached further for yield than ever before, with a record amount of cash poured into high-yield, emerging market and long-duration funds.
After last month’s spike in the 10-year rate (which rose from 2.15% to 2.55% during June), many retail investors pulled every dollar that they had invested in high yield this year, leaving the asset class with a net outflow of $5.8 billion year-to-date.
While emerging market ETFs maintain positive yearly inflows, this riskiest of credit classes lost 10% of its asset base, with outflows of $2.5 billion against total assets of $27 billion, according to fund data provider Lipper.
Indeed, at the end of June Lipper noted that investor capital was fleeing the non-taxable bond universe at the alarming rate of almost $5 billion a week. Although this number seems small compared with the $3.7 trillion of capital invested in fixed-income funds, the rapid rush for the door has overwhelmed the traditional relationship between interest rates and credit spreads.
Credit spreads should narrow during periods of increasing interest rates but the rapid run-up in the 10-year rate has reversed this negative correlation, with market technicals driving spreads wider across the US and emerging markets credit spectrum. Indicating a gaping void between market expectations and the Federal Reserve’s own perception of the economic fundamentals, the sharp spike in 10-year rates has affected every credit bucket from triple-A quasi-sovereigns to triple-C junk bonds.
The pain has been most obvious in emerging market credit, with the Bloomberg USD Emerging Market Sovereign Bond Index down by 6.22% for the month of June at the time of going to press, and the emerging market corporate bond index down 4.94% for the month.
June also saw the Standard & Poor’s US Investment Grade Corporate Bond Index fall 3.07%, pulling its annual performance down to minus 3.71%. The US High Yield Corporate Bond Index dropped 3.23%.
“June’s volatility has been the most severe we have seen in the past five years, with high-yield bonds experiencing considerably more volatility than investment grade given their longer duration and additional credit risk,” says James Rieger, vice-president, fixed-income indices, at S&P Dow Jones Indices in New York.
When bubbles burst, herd mentality overwhelms rationality, especially where retail investors are concerned. Although it remains to be seen whether the economy will allow the Fed to stick to its intention to start tightening monetary policy at the end of July 2014, US bond investors, after their rude awakening this month, are apparently not sticking around to find out.
“Although the tone has improved in recent days, investors are playing very defensive, trying to reduce duration and credit risk by selling off long-dated instruments and anything emerging market or high yield,” says Hans Mikkelsen, senior credit strategist at Bank of America Merrill Lynch Global Research in New York.
However, life insurance companies and pension funds are less sensitive to convexity issues, and prefer wider credit spreads and higher absolute yields that will enable them to meet their long-term liabilities. These accounts have been selectively buying at the new wider levels over the past few weeks, although not as much as the sell side would have liked.
“Higher interest rates and wider credit spreads make better sense for the longer-term buy-and-hold investors and they have certainly appreciated the increase in the risk-free rate. But even they have been buying less than they might given the volatility,” Mikkelsen notes.
With the 10-year rate jumping around erratically above the 2.5% level in the final week of June, the lack of strategic conviction in the Street is bordering on panic. “Although we have seen recent stability, uncertainty remains high and rates can increase very rapidly,” Mikkelsen says.
Increased exposure to credit risk and duration has been well documented over the past few years, and most investors who play in credit have been overweight the asset class. All have suffered in recent weeks, including the hedge funds that bought into high yield on a leveraged basis. Mikkelsen suggests that the unwinding of these positions is partly responsible for the excessive volatility seen in high yield.
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| Mark Okada, chief investment officer at Highland Capital |
Investors note that liquidity is understandably suffering as market makers are now even more reluctant to put capital to work. Mark Okada, chief investment officer at Highland Capital in Dallas, reports that on top of rising rates, emerging market credit investors are facing the additional challenge of reduced credit research capacities and balance-sheet availability for the asset class among the dealer community.
“Emerging market credit is demonstrating the most dysfunctional behaviour, at present, in terms of liquidity provision,” he says. “The bid-ask is very wide, and bond holders are finding underwriters offering bids points back from where the bonds are marked. The question of where real liquidity is, versus marked or quoted is an interesting one.” Despite the massive retail outflows, and a 60bp move wider on a yield-to-worst basis, the high-yield price action has not rattled the asset class’s specialist investors. Indeed, Okada was braced for worse.
“I thought the price action in high-yield would be worse than it has been,” he says. “As they got wind of worsening market conditions, the issuers put out a massive new issue calendar in April, just as liquidity was beginning to tighten up. Some new issues are down several points after launch. Valuations had become so stretched with yields close to all-time lows, that we passed on most of the calendar.”
As retail money has fled fixed-income credit product, some of it is finding a home in the floating-rate haven offered by leveraged-loan mutual funds. For several years, loan market advocates have been pointing to the strong credit performance of the issuer universe, as well as the resilience of collateralized loan obligation structures throughout the worst of the financial crisis.
Since the start of the year, retail investors have poured some $24.6 billion into bank loan funds, according to Morningstar, almost equal to the size of the entire emerging market fund market, and participants expect that number to keep growing this year.
“We’ve seen very significant fund inflows into loans this year with investors that are worried about interest rate risk rotating into a floating rate asset with more attractive pricing that offers a stable investment in a volatile market,” says Okada. “Although high-yield has outperformed over the past few years, loans are now outperforming high-yield on a year-to-date basis. The relative outperformance is finally hitting.”
Although credit markets started showed tentative signs of stabilizing by the end of June, with US investment-grade and high-yield markets posting a few days of marginal positive performance in the last week of June, most investors remain cautious about jumping back in. In the eye of the storm, is it too early to say if the market is pricing in the correct pace of policy withdrawal?
“Bonds bought at these levels may turn out to be fantastic purchases if that pace was too quick, but they will be premature if the market is too slow,” says BlackRock’s Rosenberg. The challenge of market timing in credit now has nothing to do with economic fundamentals or credit risk, but how quickly the Fed can go into reverse, and the faster it does that, the bigger the mess it risks creating.