A Bubble in Fixed Income?

Written by Stephen Swanson

Following the Great Financial Crisis, central banks of the advanced economies in coordinated fashion adopted extremely accommodative monetary policies to (1) address liquidity shortages arising from frozen credit markets (2) plug holes in bank balance sheets (3) reduce interest rates and (4) contain economic contraction and stimulate growth through expanded bank lending.

As part of seamless support, central banks continued with unconventional monetary policies, including ZIRP and large scale asset purchases, to redouble efforts to stimulate growth and increase employment while addressing strains and imbalances revealed by the economic contraction following the GFC, including divergent levels of competitiveness, unsustainable trade flows, flaws in the EMU and dangerous linkages and feedback loops between insolvent sovereigns and insolvent host banks.

On Wednesday December 12^th, the Federal Reserve expanded upon this broad policy by amending QE3 and announcing purchases would increased to include US Treasuries at a rate of $45 billion per month beginning in January, 2013 without discussing how the program might be modified or terminated. Combined with purchases of $40 billion per month of MBS, this will increases total purchases under the program to $85 billion per month for an indefinite period.

The Committee also recast its forward guidance to clarify how it expects its target for the federal funds rate to depend on future economic developments. Specifically, the Committee

“anticipates that exceptionally low levels for the federal funds rate are likely to be warranted “at least as long as the unemployment rate remains above 61⁄2 percent, inflation over the period between one and two years ahead is projected to be no more than half a percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Though largely anticipated, the Fed’s announcement only heightened concerns among many fixed income investors already worried about the Fed’s swollen Fed balance sheet ($2.9 trillion) and misallocation of capital in an environment inviting inflation. Adding another $trillion or so will only increase the odds of a bond bubble while pushing the day of reckoning further out. Many are making the case for a generational bear market in bonds.

Before discussing bond market dynamics and risks in any greater detail, it might be constructive to understand what the Fed hopes to accomplish through large scale asset purchases. And to our benefit the Federal Reserve is refreshingly frank and uncharacteristically clear as to what it hopes to achieve through policies incorporating asset purchases. Brian Sack of the NY Fed writes:

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

So, in addition to reducing interest rates the Fed hopes to effect a portfolio rebalancing under which Treasuries, MBS and agency debt – the supply of which have all been reduced – are replaced by purchases of other assets similar in nature. Essentially, then, the Fed is encouraging investors who would normally invest in Treasuries to seek higher yields from from investment grade corporate debt; is encouraging those who invest in investment grade corporates to consider higher yielding “junk” bonds; and is encouraging real esate investors who normally invest in agency backed debt to consider non-agency debt.

Notwithstanding the proviso “to the extent investors are willing to substitute”, the Fed wants to see a portfolio migration towards riskier assets to the benefit of all economic and financial sectors. They know there will be a substitution and to suggest otherwise is naïve.

The actions of the Federal Reserve, along with those of other central banks, have inspired a global search for yield with fixed income investors scouring the globe, screening all classes of debt and bidding-up prices and lowering yields across the board. This process has run the gamut and this year we have seen a decided shift to riskier asset classes.

US 10 year Treasuries started the year yielding 1.88% and rose in price amid the euro crisis to yield 1.40% on July 24^th only to see prices edge down to yield 1.70% today. This translates into gains of around 3.1% while Bloomberg’s US Investment Grade corporate index is up 9.1% YTD and their US High Yield index is up 14.9% YTD. European Corporate Junk (CCC) is up 23% YTD and a number of emerging market debt funds (hedged but not leveraged) are up over 20% YTD.

At the same time – to feed this appetite for yield against a backdrop of reduced supply and deleveraging – debt issuance in many asset classes is at or near record levels. US corporate debt issuance in 2012 will easily exceed the record level established in 2007 when corporations raised $1.1 trillion through debt offering. US corporate debt issuance through October of this year already stands at $1.1 trillion, which represents an increase of 26.4% over 2011. And if to underscore the shift towards riskier assets, high yield issuance in 2012 is running 36.0% ahead of last year.

And in the latest sign of just how desperate return-starved investors are for incremental yields and their increasing willingness to go down the credit curve to chase them, El Salvador and Mongolia recently pulled off issues that stunned the market in both their pricings and take-up rates.

El Salvador raised $800m from international investors with a 12-year dollar-denominated bond. The issue, which attracted $5.1bn in orders, was priced at a yield of just 5.875 per cent. This compares with Portugal’s 10-year bond yield, which currently sits at 7.407 per cent.

Meanwhile, Mongolia, which has been something of a darling among EM investors in recent years but whose shine has been tarnished by weaker global commodity prices and changes to foreign investment rules, succeeded in raising $1.5bn in a two-part offering.

The increased issuance and rapid absorption of higher risk debt is quickly replacing excessive levels of bank debt as a long term structural threat to economic stability. And the Fed and other central bankers have demonstrated an alarming calm to unsustainable policies to foster economic growth and accommodate the will of progressive political leaders. It is feared central banks will continue to enjoy their unblemished record of ignoring unintended consequences.

This has led to consternation among some of our leading investors who are withdrawing from debt markets, curtailing additional investment or limiting future investments. Among those radically rethinking their fixe income strategy is Michael Sabia, chief executive of the Caisse de dépôt et placement du Québec, who recently told the Financial Times:

“Our view on this is that the party is over, that therefore the eight to nines [per cent yield] we were earning are going to be replaced with twos, threes, maybe fours.”

The pension fund’s sentiment ecoes that of GMO which said it had “given up” on long-dated sovereign debt. If GMO is right and prices of government debt fall, its decision to offload bonds could prove to be a coup to rival its refusal to buy dotcom stocks well before the peak of the internet bubble in 2000.

Jeffrey Gundlach, the co-founder and chief executive officer of DoubleLine Capital LP, recently explained that the first phase of the coming debacle consisted of a 27-year buildup of corporate, personal and sovereign debt. That lasted until 2008, when unfettered lending finally toppled banks and pushed the global economy into a recession, spurring governments and central banks to spend trillions of dollars to stimulate growth.

“In the ominous third phase, he predicts another crisis: Deeply indebted countries and companies, which Gundlach doesn’t name, will default sometime after 2013. Central banks may forestall these defaults by pumping even more money into the economy – at the risk of higher inflation in coming years.”

And more recently Ray Dalio of Bridgewater at the Dealbook Conference expressed concern about the cumulative effects of large scale asset purchases by the Fed, particularly the compression of risk premia, negative real interest rates and the artificial lowering of discount rates used to calculate net present values or internal rates of return of prospective investments. He believes each successive round of QE is offering reduced marginal benefits to the economy and envisions a possible scenario in which there is economic decline brought on by, among other things, fiscal drag and diminished returns from QE. In this scenario fiscal drag brings on a contraction and the Fed’s revered tool kit is empty, leaving few, if any, policy responses.

Perhaps more seriously, Mr. Dalio foresees a day when the “term structure of interest rates back-up” (meaning they increase) which will have a pervasive effect upon all asset classes as the discount rates used in investment analysis will increase across the board. Before this happens, though, there could be further compression of risk premia and then, maybe, in late 2013 we could see things uncoil. And in his view, which cannot be ignored, when rates do increase there will be a wide re-pricing of debt and unique opportunity to short fixed income.

Unlike guests who appear on CNBC gushing with certainty and actionable ideas, Mr. Dalio is far more restrained and believes those who see things through a crystal ball are doomed to eat glass. This may explain why he is often elliptical in his answers, offering little more than asked for while carefully measuring his words.

Beyond waiting for the great short he sees room for gold and emerging market currencies in forward looking portfolios while your humble analyst, who believes there will be further compression of risk over the short term, would add to this hypothetical portfolio HYG (iBoxx High Yield), a commodity basket and staying long risk by selling protection on the CDX High Yield.

Like others, though, it is believed the big opportunity will be to short fixed income when the opportunity presents itself.