US Debt Markets
The relentless spread-widening trend seen on US debt markets since the beginning of May remained in effect this past week, with the Morningstar Corporate Bond Index widening another 3 basis points to 153 basis points above Treasuries. Since peaking at plus-134 on the last day of April, the index has now widened 19 basis points to its weakest level of the year. The move wider has been relentless: The index has widened on 29 of the 33 trading days since the start of May. Amid the turmoil in Greece, financials remain the market's Achilles' heal, widening 6 basis points during the week to cap off an 18-point beating since the end of May. Industrials, on the other hand, barely budged last week.
Morningstar Investment Conference Insight
With the market providing seemingly better value today than a couple of months ago, the number of fixed-income opportunities certainly must be getting larger. As we pointed out last week, though, the economic backdrop is darkening a bit, making investors more cautious. With these countervailing forces in mind, we eagerly attended the "Bond Bargains and Land Mines" session at the 2011 Morningstar Investment Conference in Chicago a week ago. The panel, moderated by Morningstar fixed-income fund analyst Miriam Sjoblom, included Bill Eigen from J.P. Morgan, Rick Rieder of BlackRock, and David Rolley of Loomis Sayles.
The panel produced a spirited discussion that generated interesting viewpoints on some of the key areas of concern in fixed-income investing. In general, the panel was optimistic that volatility in the marketplace, driven by the end of the second round of quantitative easing, is creating opportunities to find value across many fixed-income asset classes. Rolley, in particular, highlighted that he is optimistic to be employed in the fixed-income world due to the plethora of bonds that need to be managed today and into the future.
The discussion began with a question on the direction of interest rates. All three panellists agreed that while rates can't get much lower, there are a number of reasons they will not move much higher either. One of the key themes expressed by the panel--and others throughout the Conference--was that QEII has effectively done what it was really designed to do: prop up risky assets. As such, with QEII ending, risky assets are now getting hit. This is good for Treasuries, as the move out of risk assets effectively keeps rates low. The panellists also agreed that QEII has had the unintended consequence of raising oil prices, creating a meaningful headwind for the economy in the form of higher gas prices.
The panellists largely expect slow growth in US gross domestic product, weak housing markets, and slower growth out of China to provide additional support for stable interest rates from here. In addition, demographics that favour fixed-income investing should create steady demand for fixed-income products. The most interesting trade idea generated from this topic was to put on flatteners, as the 5s/30s rate curve is exceptionally steep. By buying 30-year Treasuries and shorting five-years, you pick up substantial yield (carry) and would benefit if the Fed starts raising rates in a rapidly expanding economy, as five-year rates would move up faster. Or, if a weaker economy removes the inflation premium in 30-year notes, 30-year rates would move down faster.
In commenting on the corporate markets, everyone agreed that high yield remains moderately attractive despite the near-record-low rate environment. A couple of panellists highlighted the widening we've seen, and would view the asset class as even more attractive with another 25-50 basis points added on top. High yield typically has a lower duration and less interest-rate sensitivity than investment grade, so the asset class tends to perform well in a slow-growth economy in which defaults also remain low.
There was some disagreement elsewhere in the corporate arena. Eigen suggested that owning investment-grade corporate bonds is akin to simply owning Treasuries, as the bulk of the return will be driven by Treasury rates. Eigen much prefers to transact in the credit default swaps market, where he has seen meaningful volatility in spread activity create opportunities to go long credit risk while shorting the bonds to capture significant spread differential. Rieder is a fan of the investment-grade market, highlighting that near-term defaults are virtually nil given the amount of cash on balance sheets today, free cash flow generation, the lack of upcoming maturities because of recent refinancing, and the liquidity in the marketplace. He hopes for additional spread widening to create more buying opportunities and particularly likes financials right now.
Both Rieder and Rolley highlighted the growth of emerging markets in the corporate bond world. Given the deleveraging going on in the US and Europe, investors will have to focus on emerging markets, and growth in those areas will necessitate funding from the capital markets. Rieder also noted that one must be careful of regulatory activity and accounting when investing in emerging economies; making a diversified portfolio is critical.
