Bond Market Update: Year Ahead 2012
While purporting to be an ancient Chinese proverb, the expression “May he live in interesting times” more commonly infers a curse (that is, may the environment be so interesting that it baffles analysis and precludes confidence in potential outcomes).
The expression, as it turns out, is neither ancient nor Chinese, and whether it is more proverb or curse, we suppose, is in the eye of the beholder. What we can say with certainty, however, is that 2011 exhibited no shortage of interesting events. And, as is generally the case, the ensuing uncertainty led to risk aversion and a flight to quality across most capital markets. In aggregate, the manifestation of this pervasive risk aversion was significantly lower rates (particularly on the long end of the yield curve) and generally negative excess returns for virtually all spread sectors.
Calendar-year 2011 started off in a fairly benign fashion. The 2010 holiday shopping season had surprised to the upside, domestic and global growth were deemed to be steady and still improving from the depths of the financial crisis, and the worst of the eurozone funding concerns were contained to the peripheral countries. The U.S. government was issuing 10-year debt at roughly 3.30% and the Italian government at roughly 4.75%. Domestic credit markets had posted fairly consistent positive excess returns, and the prospect for more of the same seemed likely. Even concerns in the financial sector had diminished, and there was hope that this sector had seen the worst of the cycle.
The winds of change began to blow, however, in the form of the earthquake and tsunami in Japan, unrest in the Middle East that resulted in several regime changes, and of course, the spread of eurozone liquidity and funding concerns to the non-peripheral countries, most notably Italy. Furthermore, the impasse around our own domestic fiscal situation was brought to light by the downgrade of all U.S. government debt by S&P on August 5. This proved to be a watershed event that changed the market paradigm completely in early August.
Our rate markets had already rallied a bit during the first half of the year, culminating in a 10-year Treasury yield of roughly 3% during June. Also at mid-year, the Italian 10-year was roughly unchanged to yield approximately 4.75%. Then, in the wake of the U.S. debt downgrade and as the eurozone pot boiled over during the third quarter, the U.S. 10-year Treasury rallied to less than 2% while the Italian 10-year traded off to a volatile range of 6.50%–7%. The former was driven by a flight to quality (interestingly, this occurred even as the securities were being downgraded), and the latter resulted from Italy being drawn into eurozone funding and liquidity concerns. A fever of extreme risk aversion spread to other markets as the third quarter progressed. Equities declined significantly (down by about 20% from peak to trough) during the quarter. In conjunction with this, amid a high level of correlation, virtually all fixed income spread sectors posted significant negative excess returns (e.g., -352 basis points for commercial mortgage-backed securities and -511 basis points for investment grade corporate bonds). During this same period, gold rallied to an all-time high of $1900 per ounce as further manifestation of the flight to quality. There was some repair to these trends during the fourth quarter, but generally not enough to offset the damage done earlier in the year.
Virtually all spread sectors posted positive excess returns for the fourth quarter (agencies and asset-backed securities were the exceptions, although the negative excess returns from each sector were slight, at -9 basis points and -28 basis points, respectively). However, given the severe damage done during the third quarter, only CMBS and ABS posted positive excess returns for the full year. Rates and curve were essentially unchanged during the fourth quarter, with the 10-year Treasury ending the year at roughly 1.9%, having traded in a very tight range around 2% since early September.
Looking at the full year in aggregate, one of the consistent trends was toward lower rates, particularly on the long end of the curve. From the peak yield in February, to the lows seen in September, the 10-year Treasury declined just over 200 basis points in yield. This type of move is known as a “bull flattening” of the yield curve, and portfolios positioned for it garnered significant excess return for the year. Although we began 2011 relatively short duration, we were able to adjust to a long position during the summer as negative economic headwinds intensified. These trades were executed on the long end of the curve and were beneficial to nominal and benchmark-relative performance for the year.
The majority of the spread sectors posted negative excess returns for the year, but there was great disparity across sectors. Within the corporate sector, utilities in aggregate posted an excess return of -160 basis points for the year, which doesn’t seem too bad relative to the -628 basis point performance of the financial sector. Even within financials there was a fair degree of return dispersion among individual names and types of institutions. This made issue selection difficult, but was beneficial to those who got it right. We were long corporate credit the entire year, but to varying degrees. We reduced exposure significantly during the spring, and then gradually increased risk as the sector got cheaper through the summer months.
Similarly, there was a fair amount of return dispersion across the structured product sectors as well. The ABS and CMBS sectors posted positive excess returns of approximately 50 basis points each for the year, and our overweight allocations to these sectors contributed to benchmark-relative performance as a result. Although the agency pass-through sector, in aggregate, posted an excess return of -106 basis points for the year, there was significant dispersion between coupons and product types. Once again, this idiosyncratic behavior made issue selection paramount to success.
To summarize, it was a difficult year for investors as a result of high volatility induced by uncertainty. The uncertainty stemmed from several variables, most notably the domestic fiscal situation, U.S. debt downgrade, and the intractable situation in the eurozone. The unprecedented nature and scale of these problems, combined with the complete inability of elected officials on either side of the pond to make progress against them, has indeed made for an interesting situation. We believe a key to success in this type of market is maintaining highly diversified portfolios—not only by means of granular position sizes, but also by diversifying risk exposures across all primary risk planes (duration, yield curve, sector, and issue).
What should fixed income investors expect in 2012? The safest forecast is usually the one that calls for more of the same. Given the political impasse surrounding fiscal repair, both at home and in the eurozone, it would be easy to say that 2012 will look a lot like 2011. Certainly, looking at the domestic situation and the differences across the aisle, it appears unlikely that we will make progress on fiscal reform this year. This situation is, of course, only made worse by the election cycle. Across the pond, EU officials, among other authorities, have taken an incremental approach to bolstering confidence in various member country finances and their ability to self-fund. The market has generally perceived these measures to be ineffectual, however, and the headlines associated with each new pronouncement induced a tremendous amount of volatility over the last few years. So why could 2012 be different?
Current valuations for both equities and bonds are a good place to start, as equity market performance in particular will be a linchpin in the year ahead. If equities do well, that bolsters financial conditions and consumer confidence which are so important to sustainable growth. Sustainable growth improves the jobs picture and the cycle become self-sustaining. Corporate earnings growth has been persistently positive over the last several years, generally surprising to the upside, and market consensus is for these trends to continue in the year ahead. Price to earnings, market to book, and other equity valuation metrics are below historical averages. While this highlights the current level of risk aversion, it also creates opportunity for improvement.
On the other hand, bond markets, particularly the U.S. Treasury market, continue to trade at or near all-time lows reflecting the flight to quality that has taken place (low Treasury yields are already pricing in a dire economic environment). Certainly, longer-dated rates could rally to still lower yields, and likely would in the wake of a macroeconomic shock such as the disintegration of the euro. That should not be the base assumption, however. Importantly, markets become anesthetized to the same piece of bad news heard again and again. The fiscal issues we’ve outlined are well-known and defined, and they have plagued the markets over the last several years. There certainly will be periods of frustration around global fiscal issues and a perceived need to deleverage, but barring a major country default or collapse of the European Union, we have likely seen Treasury yields at their lows.
We believe that in the year ahead, an underweight to Treasuries is warranted based on valuations. Good and improving corporate fundamentals, in conjunction with valuations that are cheap relative to historical norms, encourage an overweight to the corporate credit sector. Issue selection will always be important to this decision and should be informed by solid fundamental research and risk controls appropriate to the mandate.
The structured product markets should continue to provide reasonable incremental carry relative to Treasuries and should be overweighted as a result. Here too, issue selection has been and will continue to be critical. We have had success expressing coupon biases in agency pass-throughs to gain a beneficial prepayment experience, and this will continue to be our tactic. The private label sectors we favor, namely high quality CMBS and ABS, should continue to add value to portfolios. We are overweight these sectors as well.
Our current overall duration posture is neutral relative to our benchmarks, but we have been opportunistic around that level, generally trading a bit long. This bias will shift if equities can sustain higher levels and markets gain confidence in sustainable economic growth. Curve slope seems likely to be static at current levels, until markets gain clarity around the fiscal issues we have outlined this quarter.