The U.S. Federal Reserve Board has yet to announce details of its plan to scale back its $85 billion-a-month bond-purchase program, other than indicating that tapering might begin as early as this month. The lack of specifics has prompted many market observers to draw their own conclusions — and they’re anxious. U.S. stock and bond funds experienced net redemptions totaling nearly $20 billion in the week ended August 21, according to EPFR Global, a financial data-gathering service located in Cambridge, Massachusetts.
“The current sell-off is about more than just the timing and duration of the taper,” observes Joyce Chang, who in December was appointed global head of fixed-income research at J.P. Morgan in New York. (She replaces Terrence Belton, who was named head of global portfolio strategy.) “It’s about the longer-term outlook for fixed-income markets after years of unconventional monetary policy and central bank balance-sheet growth, which had contributed to broad asset reflation across all asset classes.”
The Fed has added nearly $900 billion to its balance sheet since the current round of asset purchases began in December, she adds.
Ethan Harris, co-head of global economics research at Bank of America Merrill Lynch, says clients have all kinds of concerns. For one thing, “they see tapering as a form of policy tightening, while the Fed views it as less easing of policy,” he says. That may sound like semantic hairsplitting, but the distinction is important to portfolio managers, especially with regard to the impact on fund flows. “Less Fed buying means a lot more of the monthly flow must be bought by private investors — hence the dramatic backup in bond yields,” explains Harris, who is headquartered in New York. “We argue that the initial sharp backup in yields is not surprising given that the Fed is making an historic policy turn. However, we expect the Fed to move in a slow manner. The last thing it wants is to undercut the economic recovery.”
Another issue is whether the promises the Fed makes today will be honored in January, when Ben Bernanke steps down as chairman. “Uncertainty about Fed leadership is contributing to market pressure,” Harris adds.
In the coming weeks and months, as specifics of the policy changes are revealed and their impacts on markets assessed, money managers will look to the sell side for guidance in positioning portfolios for optimum gains. The insights they value most highly come from analysts at J.P. Morgan, the leader of Institutional Investor’s All-America Fixed-Income Research Team for a fourth consecutive year. The firm captures 52 total team positions, one more than last year, and 20 of those are for analysts and teams deemed the best in their respective sectors. That’s twice the number of first-place positions captured by Bank of America Merrill Lynch, which repeats in second place overall; its total climbs by three, to 42. Barclays holds steady in third place despite losing six positions, leaving it with 32. Rounding out the top five, as last year, are Goldman, Sachs & Co., whose 25 spots reflect a gain of two, and Wells Fargo Securities, whose total increases by one, to 21. Survey results reflect the opinions of nearly 1,800 buy-side analysts and money managers at more than 500 institutions managing an estimated $9.6 trillion in U.S. fixed-income assets.
Research directors hold differing views as to what strategy the Fed will follow. Chang, of J.P. Morgan, believes that the central bank will begin winding down its asset-repurchase program this month and bring it to a close by June 2014.
“The key concerns from our clients center on the outlook for inflows into fixed-income markets and whether there will be significant outflows and rotation away from fixed income into equity,” she explains. “As the Fed begins to taper its purchases, there are also questions about the extent to which net issuance might pick up. Namely, will supply-demand dynamics point to higher yields?”
U.S. corporate bond issuance jumped 32 percent year-over-year in 2012, to a record $905.6 billion, according to Fitch Ratings. The rush by companies eager to avail themselves of historically low interest rates continued into this year, with new offerings totaling $547.4 billion in the first seven months, the London- and New York–based data services provider reports. The pace began to slow over the summer, however, as talk of policy changes took hold.
“We believe that corporate bond issuance will continue to slow as yields rise,” Chang says. “Debt levels had been rising faster than [earnings before interest, taxes, depreciation and amortization] as companies took advantage of low rates to issue, but profit margins remain near the decade high and cash balances are at a record level.”
BofA Merrill’s Harris believes central bank action is not imminent. “While it is a very close call, we expect the Fed to delay tapering until December,” he says. If the scaleback does begin this month, Harris says, it will either be a small move — a $10 billion- to $15 billion-a-month reduction, he estimates — or the plan will be couched in “dovish language about a slow exit, softening the blow.”
He cites three reasons why the Fed may maintain the status quo a bit longer. “First, while the Fed clearly wants to taper this year, it does not seem to be in any hurry,” Harris observes. “For example, minutes of the July [Federal Open Market Committee] meeting showed a committee that was still very much in the middle of a debate and was not even considering the size and logistics of tapering.”
Although the U.S. economy is showing encouraging signs — last month the Commerce Department revised its annualized second-quarter figures for real gross domestic product growth from 1.7 percent all the way to 2.5 percent, more than double the 1.1 percent first-quarter rate — its performance is still weaker than the Fed’s forecast of 2.9 percent for this year. Unemployment remains high; consumer price increases, low. “The Fed expects a steady pickup in growth and inflation, but the data remain very mixed going into the meeting,” Harris says. “Indeed, the FOMC will likely be marking down its growth and inflation forecasts.”
Then there is the issue of political gridlock. “The September FOMC meeting takes place in the middle of another likely contentious round of negotiations in Washington on the annual budget and the debt ceiling,” he notes. “Our motto: Tiptoe through the tapering.”
Lee Brading, head of credit research at Wells Fargo in Charlotte, North Carolina (and also the No. 1 analyst in High-Yield/Building for a second straight year), shares a similar view. The political environment in Washington remains polarized and highly toxic, he contends. However, despite bellicose talk on everything from defunding the Patient Protection and Affordable Care Act of 2010 to a potential government shutdown, he believes that ultimately Congress will take the path of least resistance: “Obamacare gets funded; the debt ceiling gets raised; nothing happens on tax reform; and either Janet Yellen or Larry Summers — two supremely qualified candidates, in our opinion — gets Ben Bernanke’s job,” he predicts.
In the meantime, the political infighting is exacerbating investor anxiety. “The whole fixed-income market has been on edge since May, when the Fed signaled that tapering may happen sooner rather than later,” Brading adds. “As a result, we have seen a significant shift to short duration or avoiding low coupons.”
William Alexander Roever III, who leads the J.P. Morgan team to victory in Short-Duration Strategy for a third consecutive year, concurs. “There is definitely increased interest in the one- to five-year segment,” the New York–based strategist reports. “Part of it is from investors that normally prefer longer-duration assets but are looking for a safe place as rates rise. But we’re also seeing interest from yield-starved money market investors extending out the curve in search of a few more basis points of return.”
Roever and his associates are advising clients to stay true to their risk preferences. “It’s hard to have both liquidity and yield in this space,” he explains. “Demand is increasingly intense for high-quality assets.” He is upbeat on the prospects for high-grade banks and brokerages, whose risk profiles have improved as spreads have tightened.
His team foresees an even different time line for Fed action. “We expect a tapering announcement at the September FOMC meeting, a cut in purchases in October and completion in June. Tapering isn’t tightening, and we expect the Fed’s balance sheet to continue to grow until tapering is finished,” Roever says. “There is still substantial uncertainty about what the Fed’s next steps will be after tapering, and for that reason we expect demand for long-duration assets to remain limited for some time.”
Indeed, questions about life after quantitative easing are as much on investors’ minds as the logistics of the withdrawal. “After years of getting acclimated to the unprecedented amount of easing rolled out by the Fed via its bond purchases, investors are worried about what exactly happens next to the economy and the markets if the stimulus is indeed going to end soon,” explains George Goncalves, head of rates strategy for the Americas at the No. 7 firm, Nomura Securities International. “The concerns include, ‘Is the recovery sustainable? Will tighter financial conditions slow down the economy?’” Money managers also want to know to how to hedge for potentially lower asset valuations, he adds.
Goncalves, who is based in New York (and leads a runner-up team in U.S. Governments Strategy), believes the cutbacks will begin this month. “Given the long lead time since May, when taper talk hit the airwaves, markets have been preparing,” he says, pointing out that interest rates have been steadily rising. The rate on the benchmark ten-year Treasury note climbed to 2.7 percent in August, up from 1.6 percent in May, and many analysts believe it could top 3 percent by the end of the year.
“If the Fed starts its tapering slowly — say, by $10 billion [a month] — then we expect a ‘sell the rumor, buy the fact’ reaction in bond markets as yields stabilize,” he says.
Wells Fargo’s Brading envisions a similar scenario. “Investors are clearly cautious about the taper. Everyone knows it’s coming. It’s just a matter of when and how significant it will be,” he says. “The economic news hasn’t been strong enough to suggest an aggressive pullback in Fed support, but strong enough that some pullback makes sense.”
In many ways, “we are in the dead zone, waiting for the Fed to finally act,” he adds. “I’ve heard from some portfolio managers, ‘Let’s just get it over with.’” Once people realize that a QE reduction doesn’t signal the end of the world, he says, investors will return to the market. “By acting sooner rather than later, the Fed would remove the uncertainty factor and allow the economy to demonstrate its ability to handle less stimulus and higher interest rates,” Brading contends. “Credit spreads are likely to remain volatile during this period of uncertainty but should start to recompress if the Fed takes action.”
BofA Merrill’s Harris is even more upbeat. “Since September tapering now seems fully priced in, the market is more likely to rally than sell off on the day of the meeting,” he predicts.
Against a backdrop of rising interest rates and high volatility, floating-rate products will likely continue to entice investors, analysts say.
“Interest in floating-rate notes is growing because of the expectation of rising rates,” says J.P. Morgan’s Roever. “For some investors shifting from fixed to floating may prove disappointing because floating-rate benchmarks like Libor often don’t rise until Fed rate increases are almost imminent. In the meantime, they may miss out on better returns on low-duration fixed-rate assets. Especially in this cycle, where it seems like Fed interest rate action is at least two years away, crossover floater investors will need patience.”
But they’re willing to take what they can get right now, according to Wells Fargo’s John David Preston. The Charlotte-based analyst guides the crew that debuts in first place in Collateralized Loan Obligations, which was added back to the survey this year. It was removed in 2010 after investor interest in the products all but evaporated.
Boy, has it ever returned. CLO issuance topped $50 billion in the first seven months of 2013 — nearly matching last year’s $54.1 billion total — and could reach $70 billion to $80 billion by the end of the year, Preston says. He identifies two reasons for the uptick. “CLOs are cheaper than some other competing assets, such as commercial mortgage-backed and other types of asset-backed securities, and they performed as designed during the financial crisis,” he explains.
Demand was especially robust in the first quarter but started to slip as investors began to worry about upcoming Fed actions. As long-term rates increased, fixed-rate CMBSs offered a higher yield than floating-rate CLOs. However, a QE reduction could contribute to “a little bit of spread widening on triple-A CLOs,” he notes, making them more appealing for investors seeking interest rate protection.
In addition, managers want to attract CLO assets before the Dodd-Frank Wall Street Reform and Consumer Protection Act’s risk-retention provisions, including a requirement that issuers hold a 5 percent interest in securitized products, take effect.
When the new rules are implemented, the market will change. “The effect will be fewer issuers,” Preston maintains. “There aren’t many that can write a $20 million check every time they issue a CLO, so you may see smaller managers look to price deals before the rules go into effect.”
Taking advantage of current opportunities in a market about to change is a recurring theme for investors in U.S. fixed income — although given the level of anxiety accompanying the uncertainty, change undoubtedly can’t come soon enough for many investors. • •
