Don’t Let the Noise Keep You Up at Night
Fixed Income Outlook
July 2015

Three subjects have concerned the markets recently: a Greek debt default and possible exit from the European Union (Grexit), the Federal Reserve’s (the Fed’s) normalization of interest rate policy and potential bond market illiquidity following a rise in interest rates. The first two are binary outcomes, which have been debated in the marketplace for years. While discussing these possible outcomes ad nauseam may be a palliative to some, in our view it doesn’t really provide much meaningful, incremental information until more definitive actions are taken. We will wait for further news on both fronts. Possible declines in bond market liquidity, however, may cause short-term disruptions thereby creating potential buying opportunities. Over the longer term, prices should find their equilibrium levels.

Greece reached another fork in the road and to paraphrase Yogi Berra, has taken it. On July 5th, Greek voters overwhelmingly voted “no” to further austerity. Whether they did this with their eyes wide open to the possible consequences remains to be seen. According to Bloomberg, as of June 2015, Greece owed a total of approximately €328 billion ($362 billion). As of September 2014, approximately 44% of that debt was in the form of European Financial Stability Facility (EFSF) loans, 17% in bilateral loans, 9% in bonds held by the European Central Bank and 8% in International Monetary Fund credits. Treasury bills accounted for only 5%. At this point, not much is held directly by investors or private banks. Greek gross domestic product (GDP) in 2014 was €215 billion ($238 billion) and as of the end of May 2015, total deposits in Greek banks were a bit over €125 billion ($138 billion). One problem, other than having too much debt relative to the size of its economy, is that for the remainder of 2015, Greece has approximately €27 billion ($30 billion) in debt maturities coming due, which is by far their tallest maturity wall. Subsequent years have much lower repayment burdens, the largest being 2019 when slightly under €13 billion ($14 billion) will be due. Also, a Cypriot style depositor bail-in would not yield enough to pay back much more than a third of total debt due, at face value, and would have devastating effects on the Greek psyche. The latest proposal would spare only the first €8,000 ($8,852), with deposits greater than that essentially losing 30% of their value. By the time you read this, I’m hopeful we will have more clarity on the whole matter, but Greece is indeed between the proverbial rock and a hard place. It is important to note that, while the knock-on effects are still being debated, the direct economic impact of Greece’s economic fate on the world’s major economies may be benign. In the grand scheme of things, regardless of its standing in the European Union, it will likely have little impact on U.S. consumers and the U.S. economy.

Coming back to the U.S., one of the chief concerns is the beginning of interest rate policy normalization. Following the latest Fed meeting, it seems a consensus has formed among economists that the most likely rise in the fed funds rate will be in September. As we have discussed in past Outlooks, this is an educated guess, but no more. The Fed is clearly concerned about being blamed for igniting a selloff in risk assets and will be extremely measured when they do decide it is appropriate to begin rate normalization. Most believe one to two quarter point hikes in 2015 are possible. We would not be shocked if they postpone rate hikes until 2016, or if the 2015 hikes are only an eighth of a point. In any case, a modest increase in short-term rates, whether this year or later, seems unlikely to derail the modest recovery we are now enjoying.

Potential illiquidity in the bond market has also been top-of-mind with investors and the press recently. The issues here are not cut and dry. Two main assumptions are at play. First, dealer bond inventories are much lower than pre-crisis levels and second, when the Fed does raise rates, there could be a mad rush for the exits by bond investors which could cause severe price disruptions. For the former to materialize, one needs to believe that dealer inventories are the primary factor in determining liquidity, and also that investor behavior will differ markedly from past experience. Regulatory changes have made it less economical for banks to hold inventory, so being rational players, they have reduced inventories in the past few years given that bid-ask spreads have not widened. Upon closer examination, the cuts don’t appear to be as draconian as the headlines imply. In a report titled “Signs of Liquidity Vacuum in Unexpected Places,” Oleg Melentyev at Deutsche Bank states that “a widely-held belief is that such inventories have declined by roughly 80% since…2007…this dataset is giving investors a wrong impression…in that it used to capture structured products as part of its definition of ‘credit instruments.’ As a result of this, tens of billions of dollars of AAA CDOs [collateralized debt obligations] that were held by…banks in 2006-2007, contributed to the peak of what was previously defined as ‘dealer inventory,’ [and also] contributed to its subsequent decline, as those holdings were written down…and sold at cents on the dollar, while having no direct impact on dealer ability to trade actual corporate bonds.” He adds that “liquidity deterioration has not been uniform across fixed income [markets].” If measured as the 12-month average daily trading volume taken as a percentage of market size, he notes that Treasuries had by far the biggest deterioration in trading depth, declining 70% as compared to their pre-crisis levels. Perhaps this is due to the fact that a much greater percentage of that market is not available for trading, as a result of the Fed’s quantitative easing (QE) related purchases. Investment grade corporate bonds show a 50% decline and high yield bonds show the smallest decline at 30%. This is not to say that Treasuries are not liquid; they are in fact still the most liquid sector of the market, but they have suffered the greatest reduction in liquidity versus other sectors of the market. High yield has traditionally always been a less liquid sector, meaning that participants have been dealing with sporadic bouts of illiquidity for years. According to a report by Goldman Sachs1, the record $48 billion in outflows from high yield mutual funds in the second half of 2014 was the largest 6-month outflow in the past 15 years. Additionally, it was also the largest relative to assets, at 11% of assets under management. By comparison, the second worst period was the 6-month period ending in March, 2008, when nearly $12 billion exited high yield mutual funds, representing more than 6% of assets. Not surprisingly, Mr. Melentyev’s advice is to take advantage of “liquidity vacuum points” in higher quality parts of the market instead of focusing exclusively on high yield.

The second assumption is also nuanced. The fear that investors head for the hills en masse at the first sign of interest rate normalization may also be misplaced. A January 2014 report by the Securities and Exchange Commission titled “Risk Management in Changing Fixed Income Market Conditions” showed that bond mutual fund flows in the months following the initial rate increases in both 1994 and 2000 equaled 1-2% of aggregate assets. Granted, the markets were much smaller back then, as were the aggregate assets in bond mutual funds, but we would posit that investor behavior has not changed dramatically. The question no one has tried to answer is: Where would the money go if there were a massive outflow from bonds? Would it find its way to riskier assets like equities or emerging markets? Would it pour into cash-like instruments? If the latter, could that not overwhelm the Fed’s attempt to raise effective short-term rates? Keep in mind that the Fed can only raise the target rate, which usually causes a commensurate rise in the effective rate, so if they are unable to do that because of an onslaught of demand for short-term paper, then wouldn’t the cause of the outflows from bond funds be muted? Quite possibly.

In short, we are not changing our view on the U.S. economy. As you know, we have been positioned for some time in higher yielding shorter maturity bonds in preparation for an eventual rise in rates here at home. We do not presently see value in low yielding investment grade bonds, even allowing for no rate normalization. Since we are typically ‘buy and hold’ investors and have been keeping cash on hand, whatever liquidity issues arise should be a net positive to the extent that we can buy bonds at good prices. Keep in mind that illiquidity is a zero sum game: for every seller that needs to sell at lower prices, there is a buyer who potentially benefits. Hopefully we can be that buyer more often than not.

We thank you for your continued trust in us and welcome your questions and comments.

Sincerely,

 
 

Carl Kaufman Simon Lee Bradley Kane


1
Goldman Sachs, GS Macro Markets Research - Global Markets Daily: HY market liquidity already tested by record mutual fund outflows.

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