If Federal Reserve policy normally looms large for bond investors, it does so doubly now. The global economy threatens to enter recession, and most central banks are in easing mode. But the Federal Reserve seems unsure of its policy as it delays its first rate hike since the summer of 2006, when it raised the federal funds rate from 5.00% to 5.25%.
The bank wants to elevate rates, but stagnant U.S. household income, slowing growth in China and much of the rest of the world and a wobbly stock market have delayed the process of rate “normalization.”
Through the uncertainty, the Barclays Aggregate U.S. Bond Index is up nearly 1% for the year through late September and up around 2.7% for the one-year period. The Barclays Municipal Bond Index is up around 1.4% for the year through late September and around 3% for the one-year period.
Oxford Financial Waits For Spreads To Widen
Brendan O’Sullivan-Hale of Oxford Financial, with $12 billion under management, isn’t interested in taking credit risk at the moment. The reward for doing so is slim in his opinion, with the Fed having pushed rates down and prices up. As he puts it, “We want fixed income to be boring. We prefer stable, high-credit-quality issues, and we’re not willing to take a lot of credit risk unless we’re receiving a lot of compensation.”
At the moment, Oxford’s portfolios are invested in very high-grade intermediate maturity bonds, municipal or taxable. O’Sullivan-Hale says the firm has been in and out of high yield and currency trades at various points over the past decade, but doesn’t find opportunity in those areas currently.
He ventures the idea that emerging market bonds might get interesting again, but that the yields are still not adequate to justify a meaningful allocation to them. It’s possible that Brazil’s and Russia’s spreads could blow out at some point as those countries feel the strain of the dramatic price decline in oil, but it hasn’t happened yet. In the late 1990s, for example, when Russia went through a financial crisis, spreads widened to a range of 600 to 800 basis points over Treasurys. Until something similar happens, Oxford will most likely be a bystander in emerging markets.
Nor are high-quality corporate bonds particularly attractive, says O’Sullivan-Hale. Instead, Oxford has chosen managers for their access to more exotic instruments such as credit card debt (in modest quantities).
Additionally, Oxford’s portfolios are in the four-year duration range, a bit shorter than the Barclays Capital U.S. Aggregate Index. There’s a risk that rates could spike, albeit not an imminent one, O’Sullivan-Hale avers.
Oxford has a wide range of clients in the $10 million to $50 million range, and O’Sullivan-Hale and his colleagues have counseled them to be patient in taking risk and reaching for yield at the moment.
Cumberland Relies On In-House Municipal Research
According to the outspoken David Kotok of Cumberland Advisors, “The biggest issue confronting investors is the Fed. The game of expectations dominates the conversation. And that’s a terrible situation in my opinion. What the Fed has done for over two years, starting with the taper tantrums, is send a sequence of mixed messages. They have introduced an uncertainty premium into financial markets. It’s hard to point to a metric that shows that—yield curve, etc.—but there is an uncertainty premium. It’s there. You see it in volatile, surprise-element, bond market gyrations.
“If they continue to raise uncertainty premiums, you get slower growth than you would normally get. The Fed isn’t helping [the] economy in this way. [When you] add to that [the] external influence of negative interest rates in Europe and flat interest rates in Japan, and we have a situation unlike anything I’ve seen in my 50-year career.”
Kotok, who shepherds $2.5 billion, sees little value in Treasurys and corporates despite some spread widening between the two over the past few months. Instead, he prefers the municipal bond market for both its relative credit safety and extra yield.
The municipal sector has 90,000 potential issuers ranging from large states such as New York and California to a small fire district that needs to buy a truck every 20 years or so, according to Kotok. It’s more idiosyncratic than the corporate sector, and it requires a different understanding of a bond indenture. The analysis requires an investor’s ability to read and project the budgets of non-uniform governments around the country. Cumberland has five analysts and a 40-year history of doing this kind of work.
Kotok and his team can get 100 basis points above the 30-year Treasury, which yields around 2.8%, with relatively safe issues. For example, the firm owns a “AAA”-rated bond issued by Yale University, which, as Kotok notes proudly, is an older institution than the United States. Cumberland is happy lending the money of its clients to Yale over the U.S. government for the higher yield the university provides. In fact, so attractive are the deals on various munis that Kotok owns them in clients’ tax-advantaged accounts.
Of course, credit analysis and safety assessment carry the day for Cumberland. Kotok doesn’t like many issues from New Jersey and Illinois, “two poster children of unfunded long-lived liabilities in pension and health-care benefits,” as he puts it. Neither will he touch Puerto Rico unless the issues are insured and the senior and credit indentures properly structured.
Kotok notes, “I worry about appropriation bonds and moral obligation bonds, promises made by governments. We’ve seen Puerto Rico use that tool to default on a bond. We’ve seen [Illinois] not appropriate money and suffer a dramatic downgrade in a credit.”
Instead, when analyzing issues from dodgy states and territories, Kotok looks for solid revenue support. For example, the covenant on some New Jersey Turnpike bonds demands that tolls be raised to cover the bonds. Kotok finds these attractive, saying, “We like a central service revenue bond in first-lien position.” While the $15 cost for a driver to go from Delaware to the Lincoln Tunnel in New York City may be burdensome to a driver, it makes NJ Turnpike bonds attractive.
Additionally, some states have a strong constitutional structure protecting lenders. They include Utah, whose constitution demands that old money be paid off before new debt can be issued.
In terms of duration, Kotok isn’t afraid of portfolios for some clients that reach out to seven or eight years. However, he prefers a barbell strategy—owning shorter and longer-term bonds that average out to an intermediate-long duration—to owning bonds with actual intermediate durations. He thinks investors have bid up the intermediate part of the muni yield curve. So his barbell bet can amplify returns if the yield curve flattens and mute returns if it steepens.
Athena Lets Managers Navigate The Risk Sectors
Unlike O’Sullivan-Hale, David Lynch at the $6 billion firm Athena Capital Advisors in Lincoln, Mass., reports that his firm’s fixed-income portfolios tend to have a mixture of 80% in high quality municipal bonds and 20% in more opportunistic funds. The latter can be private equity funds through which Athena’s clients gain fixed-income exposure.
Athena is a manager of managers. Most of its clients are taxable investors, making the municipal bond exposure attractive as the anchor of their portfolios.
The firm operates with an awareness of a client’s home jurisdiction, but, as Lynch says, “We do believe there are opportunities around different areas. Our Puerto Rico exposure is through hedge funds and private equity. “
Athena’s core municipal accounts are higher-grade bonds. “We’re able to hold these municipal bonds in [separately managed accounts],” says Lynch, so they are not subject to the vagaries of fund flows.
Athena also owns some high-yield corporate bonds. Lynch says there’s no substitute for good credit work, and he’s willing to give some managers the ability to search for high-yield issues. “Good managers can find good bonds,” as he puts it. On a headline basis, the high-yield market will have bad days, and its problems could spread to other markets. But Athena can be patient through the volatility.
Athena also has exposure to non-agency mortgages through mutual funds. The firm isn’t underwriting real estate loans directly, but it’s using managers to get its clients exposure.
The duration for Athena’s core muni portfolio is around the four-year duration of the Barclays 1-10 Year Municipal Index.
Keeping The Safe Money Safe
All these advisors have reminded clients seeking yield that bonds are their safe money. And the clients, for their part, accept the situation.
Of course, it was easier to tolerate low bond yields when the stock market was roaring for six years through 2014. It remains to be seen, however, how long prodigious stock returns can cover for the lack of yield in the bond market, and whether the Fed’s rate “normalization” process bodes poorly for both stocks and bonds.
According to Janet Yellen’s late September statement, delivered at the time of this writing, she’d rather begin the tightening process gently before the end of the year than risk potential future inflation demanding a greater Fed response.
Indeed the Fed’s brake pedal is notoriously stronger than its gas pedal, and Yellen would clearly prefer to tap the former gently before it becomes necessary to apply more pressure.
Perhaps this latest statement from Yellen brings her closer to removing some of the uncertainty that Kotok has decried. Or perhaps it reflects an urgency indicating the Fed is losing control of the financial markets.