Tapering Isn’t Tightening
With 10-year Treasury yield at 2.90% versus 1.55% last year, the bond market is making headlines. Managing Director and Chief Investment Officer Mary Ellen Stanek shared insights for bond investors in her annual address at the Baird Advisors Institutional Investors Conference in Kohler, Wis. Stanek commented on the bond market, the Federal Reserve, extension risk, the municipal bond market, the economy, and offered a forecast for the coming year. Following are highlights from her speech.
On the U.S. Economy: “While the U.S. has gained a bit of momentum and feels like it is on stronger footing, the economy is not materially different than it was last year. We still see moderate economic growth challenged by significant headwinds that are keeping inflation safely below the Fed’s target levels.
On Bond Market Performance: “Every sector and index posted a negative second quarter return. For the first half, the only sectors with positive returns were short maturities that have limited interest rate exposure and high yield, which typically acts more like equities.
“We’ve said for a few years that TIPS looked overvalued. TIPS underperformed regular Treasuries by more than 5% in the second quarter. TIPs do offer inflation protection over time, but they don’t necessarily protect against rising rates.
“Emerging market debt was the other worst performer in the quarter and first half, affecting many investors who had stretched for yield and higher return potential.
“In short, there was no place to hide. Selling pressure put additional stress on the market and yield spreads on non-U.S. Treasury sectors generally widened amidst the volatility.
“For us, this creates opportunity.”
On the Federal Reserve: “Ben Bernanke surprised the market in late May by signaling he would reach for the ‘tap’ sooner than expected with taper talk. The market was even more surprised in June when he confirmed the taper would likely begin in late 2013 and could be complete by mid-2014.
“The Fed’s extraordinary policy response consists of both conventional interest rate policy and unconventional balance sheet policy – namely quantitative easing. In 2008, the Fed took short rates to zero forcing investors out the “risk curve” to higher risk assets and forcing people off the sidelines where money market investments were essentially earning nothing. This was positive. The unconventional policy of balance sheet expansion by the Fed through bond buying pushed long-term rates artificially low. With the announcement of the taper, the market is finding a new equilibrium level at higher interest rates assuming the Fed will not be buying bonds after mid-2014.
“It is important to note that tapering is not tightening. The Fed’s conventional interest rate policy is not changing and will remain as accommodative as it has been with a near-zero fed funds rate continuing for years.
“The Fed surprise caused rates to rise and spreads to widen. Compared to pre-crisis levels, we believe that corporate spreads still look attractive, especially given a backdrop of continued strong credit fundamentals which are as strong as they have been in decades. Given this backdrop, the volatility we just experienced created attractive bottom-up opportunities for us, especially in the corporate sector.”
On Extension Risk: “We have been concerned about potential mortgage extension risk over the last couple of years and have been underweight agency mortgage pass throughs for some time. While mortgage rates have risen just over 1% year to date, mortgage durations have doubled by extending three years. Extending durations in a rising rate environment are very painful.”
On Municipal Bonds: “Investors should be worried about what is happening in Detroit as it is not an isolated event. However, we don’t believe it will become commonplace.
“For the last several years we have cautioned about ongoing stress in municipal credit fundamentals due to both a slow recovery in tax revenues and unfunded pension liabilities. Downgrades have outpaced upgrades by over 4 to 1. Until recently, strong investor demand overshadowed these fundamentals. Investors, in their reach for yield, seemingly turned a blind eye to risk and lower quality issues outperformed higher quality.
“We’ve encouraged investors not to go too far down in quality or too far out the curve. This year, investors who did underperformed. Lower quality BBB municipals are down 8% so far in 2013 versus 3.7% for AAA municipals. Through the end of August, long munis are down over 9% compared to intermediate maturities which are down 3%.”
On the Outlook for Economy Growth: “Economic growth over the last four years has been disappointing and below potential due to structural headwinds. Yet the U.S. is still outpacing other advanced economies, and this moderate growth in the U.S. has led to stubbornly slow improvement in labor markets.
“Tracking the unemployment rates is tricky due to labor participation issues, so we instead focus on job creation as a better guide to the health of the labor market. Job creation has been positive, but stubbornly slow and well below what it should be at this point in the recovery.
“Despite this tepid job growth, there are several reasons to be cautiously optimistic that we are moving into a more broad based durable recovery in the U.S. Auto sales are back to pre-crisis levels. Housing is once again contributing to economic growth. Household net worth that combines the value of housing and investments is back above pre-crisis levels. The U.S. energy boom and the increase in domestic energy production has created new jobs, reduced our reliance on foreign oil, and creates a more reliable and stable source of energy for our economy – a key driver of the manufacturing renaissance. Consumer debt expense is down due to deleveraging and lower interest rates that have enabled consumers to refinance at attractive levels, though we remain concerned about the level of college debt – up 70% in the last five years.
“These positives are offset by the headwinds of overall weaker global growth and the reversal of global capital flows out of emerging economies like India and Brazil due to the Fed’s quantitative easing taper. Additionally, several geopolitical hot-spots in the world, led by Syria, represent further headwinds of uncertainty.
“Fiscal drag due to the tax hikes and spending cuts from the fiscal cliff negotiations and the sequester will have a significant impact in 2013, taking out almost 2% of GDP, but much less in future years. However, fiscal policy uncertainty will continue to drag on the economy. We are likely to hit the $16.7 trillion debt ceiling by mid-October. Add to this concern over who will be the next Fed chairman. This negatively impacts confidence and is weighing on the markets.
“The Fed’s gauge of consumer inflation is well below the 2.5% threshold that would create inflation concerns. Wage pressures remain virtually non-existence. We do not expect inflation to be a problem for some time.”
Bond Market Outlook: “While the planned tapering has shifted rates upward in the near term, a lower rate environment is still likely to persist for an extended period of time. The yield curve remains steep and yield spread volatility creates opportunities.
“In this environment, we seek a yield advantage over the respective benchmarks and try to benefit from attractive ‘roll down’ as higher yielding, longer maturity bonds approach maturity. Opportunities exist in spread sectors; we are significantly underweight the US Treasury sector and find better opportunities in corporate bonds. Risk control is critical given a higher risk environment.
“Municipal yields offer great relative value relative to Treasuries and high quality corporate bonds. Here it is also important to remain high-quality focused and not to extend too far out the yield curve.
“With the upward adjustment in yields, a steeper yield curve, and solid fundamentals, we see attractive opportunities and believe that core fixed income will continue to play an important role in overall asset allocation.”
Mary Ellen is Managing Director and Chief Investment Officer of Baird Advisors. She has more than 30 years of investment experience managing various types of fixed income portfolios. Prior to joining Baird Advisors, Mary Ellen was President and Chief Executive Officer of Firstar Investment Research and Management Company (FIRMCO) and was Director of Fixed Income. She is responsible for the formulation of fixed income strategy as well as the development and portfolio management of all fixed income services. Baird Advisors manages $18.2 billion in fixed-income assets.
Baird is an employee-owned, international wealth management, capital markets, private equity and asset management firm with offices in the United States, Europe and Asia. Established in 1919, Baird has approximately 2,800 associates serving the needs of individual, corporate, institutional and municipal clients. Baird has more than $100 billion in client assets. Committed to being a great place to work, Baird ranked No. 14 on FORTUNE’s 100 Best Companies to Work For in 2013 – its tenth consecutive year on the list. Baird’s principal operating subsidiaries are Robert W. Baird & Co. in the United States and Robert W. Baird Group Ltd. in Europe. Baird also has an operating subsidiary in Asia supporting Baird’s investment banking and private equity operations. For more information, please visit Baird’s Web site at www.rwbaird.com.
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