As readers of this blog know, Dan Fuss of Loomis Sayles is my favorite fixed income investor of all time. His record is second to none. Here is his recently published quarterly newsletter. Always a good read.
July 2, 2013
Well, the bond market is no longer
boring! The second quarter was not only disappointing but quite volatile.
Year-to-date, the same phrase applies. Fortunately, on a
comparative basis, your account did relatively well. The accounts'
sensitivity to the overall market had been brought down over the last year and
a half or so and that turned out to be fortunate. Nonetheless, the
absolute return was disappointing. A lot more detail will be forthcoming
shortly.
Our forecast, for some time now, is that we are in the foothills of a secular rise in interest rates. Well, it turned out the first "foothill" was quite something. From the low of last summer, 10 year Treasury yields have risen approximately 1%. That may not seem like a lot but going from 1.47 to 2.47 adjusts bonds prices quite a bit. Thirty year bonds that were issued in the summer of 2012, at par, were quoted at the end of June in the low 80s. Most of that move actually came in the last six weeks of the second quarter. So what happened?
The proximate cause of most of the price drop was a statement followed by clarification from the Fed. You have read about that. That was quickly followed by a number of speeches from individual members trying to clarify what they meant. Nonetheless, the outflows from the mutual funds and selling of the ETFs really picked up momentum. What helped the market really crescendo on the down side was apparent selling of shorter Treasuries by foreign central banks (an inference drawn from the record drop in Fed Foreign Holdings) and the secondary impact from a liquidity squeeze in the Chinese Market. Some observers call it the "perfect storm" and I agree with that. Further amplification came from heavy selling in high quality short-term corporates, a normal secondary reserve for mutual funds and others, that found no bid.
One change in the bond market is now very apparent. The "middle of the market", otherwise known as dealers, is now relatively much smaller than the "buy side" and far less able to provide liquidity to the market. The dealer capacity to provide a thick buffer that dampens the volatility of buying or selling is much reduced. Thus, volatility increases.
So what might be coming?
It does appear to me that the first step in the rise of interest rates turned out to be a much bigger one than would be expected under the circumstances. Viewed from a more "fundamental" perspective, the global and domestic economies really don't seem to be all that strong. The Fed has put forth an economic forecast that will help guide their activity. Based on that forecast, it does not seem likely that they will allow short-term rates to rise for quite a long time, perhaps a couple more years. The question then becomes what about their buying of intermediate and longer-term Treasuries. When will they start to "taper"? That, of course, is up to them. Nonetheless, when they start and the amount of "tapering" doesn't look likely to be hard on the market for the foreseeable future. That's the good news.
The bad news is that fund flows out of mutual funds and ETFs have already started and people are now cautious on fixed income. The retail end of the market certainly does not look promising. Partially offsetting this is a quite visible rise in the institutional flows of money to fixed income. We will just have to see how this plays out. The institutional flows basically head towards intermediate and long maturities as well as below investment grade in many cases. The retail outflows seem to be primarily from intermediate and long investment grade corporates, plus from high yield and emerging market funds.
To sum up: It looks like the first phase of the first cycle in a secular rise of interest rates is already over. The market is thinner and so moves like this will come quickly and be sharper. The recent market disruption has caused some buying opportunities, particularly in the high yield and intermediate investment grade corporate area. When the second leg starts and from what level is yet to determined. Our best guess is that yields will be a bit lower before the next rise starts and it's a little bit further out than the market seems to anticipate. That is yet to be seen. What does seem apparent is that the market will be more volatile going forward and that can be viewed positively since it will provide periodic buying opportunities. Thus, our focus continues to be to position your account to take advantage of a longer-term rise in interest rates. With a lag, the income generation of the portfolio should rise. The trick will be to keep the capital base steady and rising at the same time. That is more than a case of “cake and eat it too” but, hopefully, it should be possible. We'll see.
Our forecast, for some time now, is that we are in the foothills of a secular rise in interest rates. Well, it turned out the first "foothill" was quite something. From the low of last summer, 10 year Treasury yields have risen approximately 1%. That may not seem like a lot but going from 1.47 to 2.47 adjusts bonds prices quite a bit. Thirty year bonds that were issued in the summer of 2012, at par, were quoted at the end of June in the low 80s. Most of that move actually came in the last six weeks of the second quarter. So what happened?
The proximate cause of most of the price drop was a statement followed by clarification from the Fed. You have read about that. That was quickly followed by a number of speeches from individual members trying to clarify what they meant. Nonetheless, the outflows from the mutual funds and selling of the ETFs really picked up momentum. What helped the market really crescendo on the down side was apparent selling of shorter Treasuries by foreign central banks (an inference drawn from the record drop in Fed Foreign Holdings) and the secondary impact from a liquidity squeeze in the Chinese Market. Some observers call it the "perfect storm" and I agree with that. Further amplification came from heavy selling in high quality short-term corporates, a normal secondary reserve for mutual funds and others, that found no bid.
One change in the bond market is now very apparent. The "middle of the market", otherwise known as dealers, is now relatively much smaller than the "buy side" and far less able to provide liquidity to the market. The dealer capacity to provide a thick buffer that dampens the volatility of buying or selling is much reduced. Thus, volatility increases.
So what might be coming?
It does appear to me that the first step in the rise of interest rates turned out to be a much bigger one than would be expected under the circumstances. Viewed from a more "fundamental" perspective, the global and domestic economies really don't seem to be all that strong. The Fed has put forth an economic forecast that will help guide their activity. Based on that forecast, it does not seem likely that they will allow short-term rates to rise for quite a long time, perhaps a couple more years. The question then becomes what about their buying of intermediate and longer-term Treasuries. When will they start to "taper"? That, of course, is up to them. Nonetheless, when they start and the amount of "tapering" doesn't look likely to be hard on the market for the foreseeable future. That's the good news.
The bad news is that fund flows out of mutual funds and ETFs have already started and people are now cautious on fixed income. The retail end of the market certainly does not look promising. Partially offsetting this is a quite visible rise in the institutional flows of money to fixed income. We will just have to see how this plays out. The institutional flows basically head towards intermediate and long maturities as well as below investment grade in many cases. The retail outflows seem to be primarily from intermediate and long investment grade corporates, plus from high yield and emerging market funds.
To sum up: It looks like the first phase of the first cycle in a secular rise of interest rates is already over. The market is thinner and so moves like this will come quickly and be sharper. The recent market disruption has caused some buying opportunities, particularly in the high yield and intermediate investment grade corporate area. When the second leg starts and from what level is yet to determined. Our best guess is that yields will be a bit lower before the next rise starts and it's a little bit further out than the market seems to anticipate. That is yet to be seen. What does seem apparent is that the market will be more volatile going forward and that can be viewed positively since it will provide periodic buying opportunities. Thus, our focus continues to be to position your account to take advantage of a longer-term rise in interest rates. With a lag, the income generation of the portfolio should rise. The trick will be to keep the capital base steady and rising at the same time. That is more than a case of “cake and eat it too” but, hopefully, it should be possible. We'll see.
Dan Fuss
Loomis Sayles
