There is a new big asset class getting very popular on Wall Street. You may think it is some new esoteric structured credit or volatility product. But guess what, it is just about the oldest product in the world—business lending, or “direct-lending” as it is being called. It has been increasingly apparent on the fringes that big Wall Street players, like Goldman Sachs, have recently taken an interest in direct lending. Now, the whole Street is getting in on the action. Major private shops like KKR and others have started direct lending funds, and the area has returned handsomely, up over 20% this year. The idea of the funds is to lend to businesses and whose credit excludes them from the usual channels.
FINSUM: These funds seem likely to do well until a recession or period of deleveraging occurs, at which time they are likely to see high levels of defaults.
The rise in yields across the world has seemed to stall over the last couple of months. Ten-year Treasuries are back under 2.9%, and while the yield curve is flattening, the risk of big losses from rising long-term yields seems to be mitigated. Not so fast. The Wall Street Journal is reporting that many of the world’s central banks are now aligning themselves with the Fed and are preparing to begin lifting rates. The pattern is emerging across both the developed and emerging markets (e.g. the Bank of England and the Reserve Bank of India).
FINSUM: We think this could be a risk for US investors. The main reason why being that one of the things that has kept long-term yields low is demand from overseas investors for our relatively higher-yielding bonds. If that changes, there won’t be such a lid on Treasuries.
Those seeking to buy income-focused investments have a dilemma on their hands right now. Is it safer to buy high-yielding blue chips like AT&T, or better to buy a diversified high yield fund? Barron’s tries to answer this question and gives a definitive opinion—the bond fund. While both may offer similar yields of between 5-6%, holding money in just one or a small handful of blue chips offers much more risk. Not only could dividends be cut, but underlying businesses could deteriorate. And without the benefit of diversification that a broad ETF offers, a portfolio could see heavy losses.
FINSUM: This is a good, basic article to share with any clients who ask why they are buying debt instead of just owning a few stocks.
All the focus in the fixed income world is currently centered around whether the yield curve will invert. However, investors should know something—the yield never inverts in municipal bonds. That’s right, the muni yield curve has never inverted. The reason why being that short-term munis are always very rich, with small supply and high demand. However, looking at longer-term yields, munis look like a great buy. While the average ten-year muni yield is only 2.43% versus 2.86% for Treasuries, for any investor in a tax bracket above 15%, buying munis makes more sense.
FINSUM: The current spread between ten-year munis and Treasury bonds makes the former look like a smart purchase right now, especially because the market seems to be in healthy shape.
The current fixed income environment is very challenging. The yield curve continues to flatten, and long-term yields have stalled, yet could move higher at any point. One great way to play the situation is through floating rate notes and funds. One floating rate fund that has been very successful is the American Beacon Sound Point Floating Rate Income, which has a 5.7% annualized return over the last five years. This year it has returned 4.5% versus Vanguard Total Bond Market Index’s -0.1%. The fund specializes in floating rate bank loans, so the higher rates go, the more those loans pay.
FINSUM: Floating rate notes and funds seem like a really good approach in the current environment, and this one might be an excellent choice.
Anybody who is worried about a pending bond bear market might take some solace in recent news. Bond markets are becoming increasingly skeptical of the Fed’s bullish stance on the economy, and traders believe there won’t be nearly as many rate hikes as the Fed says. The US has just seen a weak inflation report, and a flattening of the yield curve, both at home and in the Eurodollar market, spells ill for the economy. So while the Fed says it will continue to hike rates into 2020, top market analysts are saying things like “The markets are telling us that there is a pretty high risk of economic slowdown or recession at the end of 2019” (Janney Capital Management).
FINSUM: We think the economy will definitely start to weaken before 2020. Perhaps we will not have a deep recession, but we definitely don’t think there will be continuous hikes for the next year and a half, which is good news for bonds.
Those who only pay causal attention to muni bonds might be scared away from the market by negative stories about big buildups in debt, bankruptcies, and a general erosion in credit quality. However, this year, nothing could be further from the truth. There has been a massive deleveraging of the sector in 2018, with total US muni bond issuance down a whopping 17% to-date, and on pace for 25% by the end of the year. The dearth of issuance has pushed yields down and prices up. “It’s a seller’s market”, says one muni bond analyst.
FINSUM: Part of the lack of new issuance is due to the federal tax changes, but nonetheless, the market is looking increasingly healthy.
Everyone knows it has not been a good year for bonds, especially Treasuries and long-dated bonds. However, did you know that it is July and the bond market is on pace for its worst annual performance in a century? (yes you read that correctly). Global bonds are on pace for an annualized loss of 3.5%. So the question is how can one keep money in the market, but not get hammered. The answer is high-grade, short-term bond funds. Floating rate corporate loans and high-yield municipals seem like good areas of focus. Remember that shorter duration bonds are less susceptible to interest rate risk, which makes them safer as the Fed raises rates.
FINSUM: These picks seem spot on to us. Higher-yielding, shorter duration, and floating rates all appear to be good selections for the current environment.
Yields have been pinned for several weeks now. Ten-year US Treasuries are currently trading around 2.86% and have been at that level for some time, while thirty-year bonds are also under 3%. The typical reasons cited for this are the looming trade war and fear of recession, which makes the bonds look attractive. However, there may be a much less obvious reason yields are staying low—a poorly known tax benefit being exploited by institutional investors. Pension funds have been devouring Treasuries as the new tax cuts incentivize companies to contribute majorly to their pension funding. And since pension funds tend to invest in long-dated bonds as a way of matching their liability timeline, long-dated Treasuries have seen massive inflows.
FINSUM: There has been so much speculation about yields being pinned, and one of the main reasons behind it seems to be a tax incentive. Very interesting to know that it is not necessarily the economic environment keeping downward pressure on yields.
Only those watching the bond market closely would have noticed it, but a huge Treasury meltdown may have started yesterday. One month US Treasury bills saw yields jump an eye-popping 10 basis points in an instant. The incident followed one of the worst Treasury Bill auctions in a decade, where there was little demand from investors. The two possible answers for the terrible auction are the unusual date (it was moved because of the Fourth of July), or that China has indeed slowed or cut off its purchases of US debt.
FINSUM: The US better hope this bad auction was just a fluke of the calendar. That view is supported by the fact that longer-term Treasury auctions at the same time were much closer to normal.
One of the big downside risks for the US in its current trade war with China concerns the fact that Beijing owns $1.18 tn of US Treasuries. They also own billions of US mortgage bonds. The big question is whether they will decide to use such ownership as a weapon against the US. For instance, if they sold off large quantities of the bonds, it could send US yields spiking. However, it seems unlikely they would do say for a number of reasons. Firstly, it would hurt the value of their own holdings and all their other Dollar-denominated assets, and it would engender a lot more punitive action from the US. Some consider it the economic equivalent of “mutually assured destruction”.
FINSUM: This is a grave risk for the US because of how it would push up rates all through the economy, but we do not think the trade war has gotten this serious yet.
Ten-year Treasuries are currently sitting at 2.85%, and according to Barron’s, they aren’t going anywhere. The reason why seems to be three part: a weak inflation outlook, trade war, and the combination of so-so growth and a hawkish Fed. All of this makes investors comfortable with sub-3% yields, and the bonds are being supported by their safe haven nature. Another problem is that US yields are much higher than in other developed countries, such as in Europe, keeping demand for Treasuries high.
FINSUM: We see longer end yields as pretty pinned at the moment. There is not much to be bullish about in the long term economic outlook, so it is hard to see why Treasuries would slide.
One of the biggest arguments of the junk bond market is this: one needs to be careful of junk bond indexes because they automatically skew investors to the companies with the most debt, making portfolios inherently more risky. The argument has a seemingly sound logic which is similar to the “skew” often referred to in equity ETFs. However, the reality is the complete opposite, as the companies with the most debt actually tend to be larger and have more conservative levels of leverage. The larger companies with the highest total debt in the high yield market tend to have lower default rates, so there is actually no correlative relationship between more debt and higher risk. The analysis is from S&P Global Market Intelligence.
FINSUM: This is very useful analysis, because the more debt = more risk fallacy is an easy-to-fall-into mental trap.
Many investors are worried about rising yields, which could wreak havoc on everything from the economy, to income stocks, to all manner of bonds. Well, for what it is worth, Morgan Stanley has just put out a piece arguing that the 3.12% yield seen on the ten-year Treasury recently is it, the peak. Morgan Stanley says that yields will stop rising and they are advising clients to go long Treasury bonds at current yields. The argument stands in contrast to Pimco and JP Morgan, who both see yields moving towards 4%. The one caveat to the call is if trade tensions get settled quickly, as turmoil on that front is one of the bullish drivers they see for Treasuries.
FINSUM: If trade tensions keep flaring we agree that Treasury yields are likely to stay flat or fall as investors flee to safety.