Economic & Market Review - June 2013

by Gavin Graham, Chief Strategy Officer June 17, 2013
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.

In my first commentary for INTEGRIS last month, I mentioned that long term bond yields were near 60 year lows, which posed problems both for investors looking for income, and for pension funds and insurance companies that had to deal with the deficits for their funds created by an exceptionally low long term discount rate. Along with numerous other observers, I suggested that bond yields would rise over the next few years, making them an unattractive asset class for investors, as their low yields provided little protection against the capital losses that holders of the bonds would suffer once interest rates began to rise.

In the month since then, there has been a dramatic demonstration of the unpleasant effects of rising yields on conventional fixed income investments. Once the US Federal Reserve (the Fed) began to suggest that it might start reducing, or “tapering”, the support it was providing to the US Treasury and mortgage backed bond markets by buying less than U$85 billion a month of these securities, as the US economy showed signs of recovery, the bond market sold off sharply.

US 10 Year Treasury yields are up 20 basis points (bps) to 2.15% in the last month and 55 bps or above 0.5% over the last year, while 5 year Treasury yields are up 20 bps and 35 bps respectively over the same periods to 1.05%. In Canada, 10 year Government of Canada bonds are up 20 bps and 40 bps to 2.1% over the last month and year, British 10 year gilts are up 18 bps and 40 bps to 2.07% and only German 10 year bonds are holding steady, up 11 bps to 1.55% over the last year, although they have seen their yields rise 22 bps in the last month.

Holders of long dated conventional government debt have suffered losses in a short period only experienced 20 years ago when then Fed Chairman Alan Greenspan unexpectedly started raising interest rates from 3% in February 1994. Now, the Fed has not even begun to raise interest rates to cause a similar sell-off, only suggests that it may reduce its support for the bond markets sometime in the next few months. Should interest rates begin to actually increase, investors will undoubtedly experience further capital erosion, although hopefully not as large a loss in as short a period as happened in the last month.

Unfortunately for investors in investment grade fixed income, there are few alternatives to developed country government debt. The yields on shorter dated US Treasuries, Govt. of Canada bonds, UK gilts and German or Eurozone debt are pitifully low, ranging from 0.1% to 0.4%. Investment grade corporate bond yields have seen the spread between their yields and government debt shrink to less than 2%, with the Bloomberg US Corporate Bond Index yielding 3% against 1.2% for the Bloomberg US Treasury Bond Index and the Bloomberg Canada Investment Grade Corporate Bond index yielding 2.87% against 1.7% for the Bloomberg Canada Sovereign Bond Index. In Europe, the UK Sterling Investment Grade Corporate Bond index yields 3.5% against 2% for the Bloomberg UK Sovereign Debt Index and the Bloomberg German Euro Investment Grade Corporate Debt Index 1.85% against 0.93% for the Bloomberg Germany Sovereign Debt Index. Lastly, inflation protected government bonds, known as Treasury Inflation Protected Securities (TIPS) in the US have a negative real yield of -0.8% for the 5 year US issue and only 0.1% for the 10 year, so do not provide any income even though they may protect the investor against increases in the Consumer Price Index over the next decade.

For non-investment grade corporate debt, the story is the same. The search for income by investors has sharply reduced the spread between high yield debt (otherwise known as “junk bonds”) and government bonds from over 10% during the Financial Crisis of 2008-09 to less than 5% today, with the Bloomberg US$ High Yield Corporate Debt Index yielding 6.7% and the Non-US$ High Yield Corporate Debt Index 5.7%. Issuers are once again reducing the amount of protection that lenders can expect against having their debt called away early or the strength of covenants against issuers taking on additional debt. Thus the buffer that high absolute yields from high yield debt offered against changes in interest rates has been much reduced and the benefit of non-correlation this provided with investment grade debt has also been substantially eroded.

Investors looking for reasonable absolute yields and some degree of protection against rising interest rates in the developed countries should look at emerging market debt, which has seen its credit ratings improve dramatically over the last two decades. Where only 5% of emerging market issuers were rated investment grade fifteen years ago; now over half are ranked higher than BBB-. The JP Morgan Emerging Market Debt Index has a weighted average yield of 6.5% and a yield to maturity of 5.1%, 300 bps higher than the 10 year sovereign debt of the US, Canada, the UK or the Eurozone. Moody’s ranks 65% of the countries in the index as investment grade, and almost all have superior demographics and most have superior balance sheets than the developed economies. While the Financial Crisis showed that correlation between developed and emerging markets approached 1 during a major financial shock (in other words emerging markets investments such as debt and equity will move almost exactly in line with those of the developed countries), absent another Lehman Brothers style meltdown, adding a diversified emerging market debt fund to the fixed income portion of a portfolio will increase its yield and should reduce its volatility.

Source: current as of June 18th, 2013