Bonds: Avoiding Volatility In A High-Uncertainty/ Low-Conviction World

  • We compare a “bi-modal” portfolio of 50% Treasuries/50% High Yields with a “middle-of-the-road” portfolio of 100% Investment Grade Corporate bonds. The latter wins in both good and bad scenarios.
  • We remain cautiously optimistic, as we believe the determination of the policy makers to prop up the market should not be underestimated, especially in an election year.

Bi-Modal or Middle-of-the-Road?

In June, our internal measure of market risk aversion across markets fell sharply—to an extreme level that we believe indicates too much complacency, particularly because our investment disciplines also indicate higher risk going forward. The result is a dilemma: there are multiple risks out there that could easily derail the fragile bond market, but at the same time, the resolve of global policy makers to support the market is equally strong.

As a result, the probabilities of a very good and a very bad outcome are both quite high. This is along the same line of Bill Gross’s “Bi-modal” world, where the likelihood of observing extreme out- comes (both up and down) is much higher than normal.

How can we avoid volatility in this highly uncertain, bi-modal world? Let’s first assume we don’t have a high conviction on the likelihood of outcomes, because the current market dynamic has moved out of the realm of traditional market analysis and into the realm of policy analysis, which is not our forte. Then there are two ways to construct a relatively safe fixed income portfolio without taking too much risk in either direction.

  1. The first option is a hedged portfolio that bets on both good and bad outcomes simultane- ously: in a simplified case, we use a 50% Treasuries/50% High Yield portfolio to proxy this strategy. We call this a “bi-modal” portfolio.
  2. The other option is simply to avoid both ends of the risk spectrum by putting 100% in in- vestment grade Corporate bonds. We call this a “middle-of-the-road” portfolio.

Which one is better? To answer this question, we look at the four historical cases of extreme market movements in the last twenty years.

  • For the bad scenarios, we use June to August 1998, July-December 2002, July to December 2008, and July to November 2011.
  • For the good scenarios, we use September to November 1998, January to June 2003, Janu- ary to June 2009, and the most recent December 2011 to April 2012 period.
  • We test the performance of these two portfolios in each scenario (using Barclays U.S. total return indexes) and summarize the results in the tables below.


The bottom line? The “middle-of-the-road” portfolio wins in both good and bad scenarios.

For additional context, the following pages provide our current views on investment-grade, high-yield, and municipal bonds. The final page provides a table high- lighting our continuing view on long-term Treasuries: limited upside potential, with significant downside potential.

U.S. Investment Grade Corporate Bonds: Moderately Favorable

The Moody’s A Corporate yield rose 5 bps to 4.16% in June, while U.S. Long-Term Treasuries yield rose 11 bps to 2.38%. As a result, the ratio of Moody’s A Corporate/U.S. Long-Term Treasuries yield declined to 1.75x. We remain Moderately Favorable on Investment Grade Corporate Bonds. With Treasury yields near record lows, and our core view of a muddle-through economy still intact, we are reluctant to move into Treasuries at this point. We favor the higher quality, higher grade sector of the credit market as a defensive play.

After seeing erratic flows in Corporate bond funds in the first half of this year, inflows have in- creased sharply in the last two months. Strong demand for relative safety and yield at the same time drives investors into these bonds. Historically strong inflows have produced strong relative performance for Corporate bonds versus Treasuries (bottom chart). Although we are usually less comfortable in a crowded trade, we still don’t see an end to the current high volatility environment any time soon.

U.S. High Yield Corporate Bonds: Neutral

The yield on the Barclays U.S. High Yield bond fell 53 bps to 7.35% in June, while the spread versus Treasuries narrowed 58 bps. We maintain our neutral view on High Yield bonds. We believe uncertainty is likely to persist in the near term. Caution is warranted.

Although we are constructive on High Yield bonds for the long term, some of the near term headwinds are hard to ignore. This is a confidence-driven market, and the current confidence picture is fragile — at best. The bottom chart shows a flagging expectations component of the U.S. Consumer Confidence Index. This historically has been bad news for High Yield bonds and the recent relative performance of High Yield/Investment grade Corporate bonds has not fully captured the deterioration in consumer confidence.

U.S. Municipal Bonds: Moderately Favorable

The Barclays U.S. Municipal Bond yield rose 8 bps to 2.45% in June. The ratio of Muni tax equivalent yield (assuming a 35% tax rate) to U.S. Corporate Bond yield increased from 1.10 to 1.15. Muni yields are currently 15% higher than taxable Corporate Bond yields, which is right around the his- torical median (top chart). The longer duration of Munis was a drag in June as interest rates were up. We continue viewing Muni bonds as Moderately Favorable.

In June, Stockton, CA, officially became the biggest U.S. city to file for Chapter 9 bankruptcy. This move was widely expected as the city has been on the verge of bankruptcy for quite some time. The default rate for Munis has been generally lower than average in the past two years. Spending cuts have been carried out more rigorously at the municipal and state level than at the federal level. And with a housing recovery looking more and more likely to gain traction, state tax revenues are likely to find further support.

The U.S. Supreme Court upheld the Obamacare law in June. The Munis market didn’t react much to it as the impact was generally considered state-specific. We expect the impact on states that have a higher percentage of uninsured population to be more negative, as these states will have to face a higher financial burden from increasing health care costs.

We still believe the second half of the year will be more volatile for Munis than the first half. Munis supply/demand picture seems to be balanced right now, with increased issuance largely offset by strong inflows into Municipal bond funds and the reinvestment cash flows that typically occur around June and July each year.

Although the fundamental picture of states and municipalities continues to improve, rising inter- est rates is a big risk going forward. The coming “fiscal cliff,” the uncertainties regarding the cost of the health care laws, as well as tax reforms, could all add to the anxiety level of Muni investors. We will be watching this sector closely and stand ready to downgrade Munis when necessary.

Long U.S. Treasuries: Upside Limited, Downside Significant

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