Fixed Income Investment Outlook
April 2013
Based on the nearly 2,500-point rise in the Dow Jones Industrial Average since last June, it appears that Mr. Bernanke has been successful in increasing demand for risk assets and creating some exuberance in the stock market. Short-term volatility in the markets may be driven by questions about the Fed’s eventual exit strategy and how effectively the politicians will deal with U.S. fiscal issues. The good news is that that the U.S. economy is growing, albeit slowly, unemployment is falling, again slowly, and consumer confidence is improving. The Fed has indicated that it will consider raising the benchmark lending rate only after the unemployment rate falls below 6.5%. Under this scenario, we believe that the U.S. economy could be strong enough to grow on its own.
Gains in asset values, including the rebound in home prices and the rally in stock prices, show that the Fed’s stimulus policies aimed at helping Americans repair their tattered finances are starting to pay off. Higher home and stock prices helped push consumer confidence in February to a three-month high. For consumer confidence to keep rising, Washington now needs to deal with our fiscal issues. We are disappointed that Washington was unable to avoid the arbitrary across-the-board spending cuts that took effect on March 1st. The sequester hits the military hard, but does very little to address automatic Medicare, Social Security and Medicaid payments, which are the long-term drivers of the deficits.
We are beginning to see signs that both parties may be willing to come to the table with the concessions necessary to fix some of our fiscal issues, but we do not see a grand bargain as part of the package. Our huge deficit cannot be solved simply by increasing taxes on the rich. We believe the U.S. needs more comprehensive and balanced legislation to reduce the deficit over time.
Since 2008, the Fed has purchased more than $2.3 trillion of Treasuries and other securities in an attempt to encourage increased consumer and business spending. It currently plans to continue purchasing approximately $85 billion of government and mortgage debt each month, further bloating its balance sheet by about $1 trillion this year. Although, Mr. Bernanke recently acknowledged concerns that his bond buying efforts might encourage excessive risk-taking and possible bubble creation, the Fed currently feels that the benefits of promoting a stronger economic recovery and more rapid job creation outweigh those risks.
One unknown is the Fed’s exit strategy. While unwinding its massive balance sheet, there is the possibility of depressing bond markets and putting upward pressure on rates, which could reverse the economic gains we’ve made. Mr. Bernanke, however, recently hinted that the Fed does not have to sell its holdings and may decide to hold its positions until maturity. This approach would help the Fed avoid realizing losses on its balance sheet when interest rates climb. Additionally, when the Fed does begin to ease the stimulus, it can induce banks to hold more reserves by paying higher interest rates on those reserves. The more reserves the banks keep idle, the less pressure there will be to quickly shrink the Fed’s balance sheet.
We believe the economy is still moving in the right direction even as it weathers the latest storm of uncertainty from Washington’s fiscal policies and the latest banking crisis in Europe. In February, U.S. employers accelerated the pace of hiring, helping to push the unemployment rate to 7.7%, the lowest in more than four years. While some may argue that the government’s estimate of the size of the workforce (the denominator) is skewed, the headline rate is nonetheless an improvement. In addition, net worth for households and non-profit groups increased by $1.2 trillion in the fourth quarter of 2012 to $66.1 trillion which was a four year high. Hopefully, growing wealth will translate into increased consumer spending.
When the Fed does eventually reduce its stimulus in response to a self-sustaining economy, we expect interest rates to rise gradually. This may even be discounted in the markets before the actual easing of the stimulus is announced. The timing is, however, uncertain. It appears that many investors already have the possibility of rising rates on their mind based on the renewed interest in floating rate and leveraged loan funds, which have seen a dramatic rise in issuance. While we appreciate the fear of rising rates, we prefer economically sensitive shorter duration bonds, with the addition of some equity sensitive convertibles. If history is a guide, there is an inherent characteristic in the floating rate product which can limit upside, namely the lack of call protection which can lead to rapid repricing of the spread paid to investors. In the years 2004 through 2006, the Fed raised the federal funds rate from 1.00% to 5.25%. For that period, the total return for leveraged loans1 was 17.9% lagging the 23.6% return for shorter-dated high yield bonds2. Although history may not repeat itself, we are comfortable with shorter-dated high yield.
Given our short-term cautious, but long-term positive outlook for the economy, we are still avoiding investment grade securities as we believe yields are not adequately compensating investors for the interest rate risk they are taking. We are also keeping some cash on hand for potential buying opportunities that may present themselves as the year progresses. As always, we will opportunistically add convertible bonds to the mix.
1 The Dow Jones Industrial Average is a price-weighted average of 30 significant stocks. One cannot invest directly in an index.
2 The S&P/LSTA Leveraged Loan Index (LLI) covers the U.S. market back to 1997 and currently calculates on a daily basis. These indexes are run in partnership between S&P and the Loan Syndications & Trading Association.
3 The BofA Merrill Lynch 1-3 Year US Cash Pay High Yield Index contains securities that are rated BB1 through BB3, based on an average of Moody's, S&P and Fitch.
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Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates.
© Osterweis Capital Management
© Osterweis Capital Management
