Wasmer, Schroeder & Company
Quarterly Bond Market Overview September 30, 2016
IT PROBABLY IS DIFFERENT THIS TIME
Billions
It should come as no surprise U.S. AGGREGATE RESERVES FOR DEPOSITORY that those of us who have been INSTITUTIONS in the business for a while had Source: Bloomberg; 3/31/2005 ‐ 9/30/2016 $180 some eerie feelings of deja vu $160 over the past few weeks as $140 headlines out of Germany $120 detailed at least a mild loss of $100 confidence in their largest financial institution, Deutsche $80 Bank. To be sure, memories of $60 those days surrounding the $40 failures of U.S. investment $20 banking pillars Bear Stearns and Lehman Brothers are not pleasant. Much of our global economy and the state of the financial markets today, in fact, still reflect those nearly decade old events. While we can never rule out a complete loss of confidence or liquidity, or a short selling attack on the bank’s shares, we tend to side with those in our world who think that the bank will survive this episode. Moreover, its solid liquidity and capital positions, forced on them in a way by the new regulatory frameworks put in place following the crisis, should allow them to remain one of the world’s most venerable institutions for years to come.
THOMAS RICHMOND, JR. Managing Director, Portfolio Manager
EMILY M. RIDDELL, CFA Vice President, Portfolio Manager
That is not the point of this commentary, however. The takeaway from the story that helps us to form our base case thesis over the rest of the year is that it serves as a reminder of what the current global state of economic affairs reflects. Rather than the end of a seven or eight year business cycle, we believe we are seeing the continuation of a much longer debt or deleveraging cycle. The world was a much overleveraged place leading up to the crisis, and the process of working off that imbalance is still ongoing. There continue to be pockets of the world’s economy that are showing signs of increased debt loads, notably many sovereign governmental entities (including, obviously, the U.S., but also Japan, China, and many European countries), some corporations (although most are multi‐nationals merely borrowing against cash trapped in other jurisdictions), and certain segments of consumer lending (Subprime auto loans again? Really?). In the aggregate, however, the lending that fueled the booms of the 1990’s and 2000’s has slowed markedly as financial institutions around the world face increased scrutiny and regulation, and hoard unprecedented sums of cash despite historically low, or negative, deposit rates. Further, gradually increasing personal savings rates around the globe also show that consumers, still thinking back nervously to the crisis and facing relatively low potential returns, may be reducing current consumption for future peace of mind as well. 600 Fifth Avenue South, Suite 210
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QUARTERLY BOND MARKET OVERVIEW
Tax Exempt Market
U.S. PERSONAL SAVINGS Source: Bloomberg; 3/31/2013 ‐ 8/31/2016
CREDIT QUALITY
900 850
Million
800 750 700 650 600 550
This belief brings us to the conclusion that, this time around, a general recession is probably not in the cards in the intermediate term despite conventional theory of business cycles. We also think, however, that the growth trajectory of the world’s economy this time around probably is different, and that 1% to 2% growth may be with us for a while. Given that we also believe that all of the cash referenced above will not be freed up anytime soon, for regulatory and demographic reasons, inflation will probably remain stubbornly low. These thoughts, along with a belief that the U.S. Fed will tighten soon, probably by December (accompanied by very dovish guidance), make us continue to think that relatively range bound rates and a flatter curve are still, as they have been for some time, the most likely outcome. That part is not different this time.
Source: Bloomberg; 3/31/2001 ‐ 6/30/2016 15%
$21 $19 $17 $15 $13 $11 $9 $7 $5
13% 11% 9% 7% 5% 3%
U.S. Total Debt Outstanding
U.S. Household Debt Service
U.S. Total Debt Outstanding (Trillions)
U.S. HOUSEHOLD DEBT SERVICE VS. U.S. TOTAL DEBT OUTSTANDING
U.S. Household Debt Service
During the third quarter; ‘A’ rated credits had the best performance followed by ‘BBB’ rated bonds. Bonds rated ‘AAA’ saw the lowest returns as investors continued to favor lower rated bonds in their quest for additional yield. As we mentioned in our last quarterly overview, PROMESA (Puerto Rico Oversight, Management, and Economic Stability Act) was signed into law by President Obama on June 30th and the commonwealth defaulted on their general obligation debt service payment on July 1st. The passage essentially created a framework for debt restructuring in Puerto Rico that did not exist before. Since the law was enacted, a seven member oversight board met, elected a chairman and requested a fiscal plan from the commonwealth. Additional meetings are expected to take place in October and November. In addition to Puerto Rico, the passage of PROMESA had implications for the U.S. Virgin Islands and Guam as they could potentially be granted access to the same framework for debt restructuring. This, coupled with ongoing fiscal weakness in the territories and downgrades from some of the ratings agencies led to underperformance of the territories’ bonds. In other credit news, Chicago Public Schools continues to struggle with a myriad of issues as they grapple with a liquidity shortfall, unrealistic budget expectations, declining enrollment, and a workforce that is threatening to strike. The Chicago Board of Education bonds were downgraded to ‘B3‘ from ‘B2’ by Moody’s at the end of the third quarter around the same time the Chicago Teachers Union voted to strike unless they can compromise with the board on a fair deal regarding contracts and school funding. We view the current credit environment as bifurcated. Good credits continue to take necessary steps to maintain healthy financial profiles and adequate reserve funds and remain worthy of investment by even the most conservative of investors. On the other hand, many weaker issuers continue to struggle with structural deficits, high
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QUARTERLY BOND MARKET OVERVIEW
regulations led to large liquidations creating a deluge of supply in the short end. This resulted in higher yields for short paper and has created an interesting opportunity in the VRDN (Variable Rate Demand Note) space for larger buyers looking for a short term place to invest cash. As a refresher, VRDNs have historically been the primary cash management tool for municipal money market funds. VRDNs are usually structured as tax exempt bonds with long maturities and floating rate coupons that reset weekly against the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index. VRDNs generally exhibit 1 or 7 day liquidity profiles that allow the investor to put the bonds back to a remarketing agent in exchange for cash. This put option is facilitated by the presence of 3rd party standby purchase agreements (SPA) and letters of credit (LOC) that are provided by large, money center financial institutions. Yields on VRDNs and SIFMA have continued to reset higher as supply remains elevated. At the end of the quarter SIFMA was 0.84%, up from 0.41% at the end of the second quarter. SIFMA 7‐DAY INDEX
debt and pension burdens, and poor demographic trends. Despite the outperformance of lower rated credits, which has persisted for some time, structural issues and the lack of long‐term solutions being put forward to address these structural issues continue to warrant an elevated sense of awareness. WSC continues to remain very selective in our credit selection within the high grade strategies. We are especially wary of municipalities with inordinately high pension burdens, particularly when there is a lack of a plan to address them. Within our credit‐centric strategies, we continue to add exposure to issuers with solid covenants and financial flexibility, albeit many times with political dysfunction. The continued dislocation in the trading levels of “good” and “bad” credits can provide opportunities for investors willing and able to conduct the necessary ongoing surveillance. That said, without proper diligence holders can be caught off guard by spread widening as many times the market tends to price in deteriorating credit conditions ahead of the ratings agencies. DURATION/STRUCTURE Municipals underperformed U.S. Treasuries during the quarter, especially on the longer end of the curve. The Municipal‐to‐Treasury ratio in 30‐years widened from approximately 95% to 102%. Ratios in 10‐years ended the quarter slightly higher at 96%. 3Q 2016 BLOOMBERG BARCLAYS CAPITAL MUNICIPAL BOND INDEX RETURNS BY MATURITY Source: Bloomberg Barclays 0.07%
0.2%
Source: Bloomberg; 9/30/2015‐9/28/2016 1.00% 0.80% 0.60%
SIFMA Index
0.40% 0.20% 0.00%
0.0% ‐0.02% ‐0.2%
‐0.19%
‐0.4%
‐0.12% ‐0.25% ‐0.34% ‐0.44%
‐0.6%
‐0.67%
‐0.8% 1‐Yr
3‐Yr
5‐Yr
7‐Yr
10‐Yr
15‐Yr
20‐Yr
Long
Municipal performance was negative for the quarter, except in the 7‐year area, which was the only portion of the curve with positive performance. The short end of the curve saw unusually poor performance as the fallout from upcoming money market fund
The negative performance we saw during the third quarter can be attributed to a similar move in Treasuries, while the underperformance vs. Treasuries was at least partially due to elevated municipal supply. Third quarter supply finished at just over $100 Billion, with $35.7 Billion issued during the month of September alone. That total is the heaviest amount on record for the month (dating back to 1986). Thus far, the 4th quarter is showing no signs of slowing down with 30‐day Visible Supply recently hitting some of the highest levels of the
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QUARTERLY BOND MARKET OVERVIEW
decline in municipal bonds outstanding. While a more detailed assessment of overall credit quality in the sector is discussed in previous sections of this report, we continue to focus on long term trends in individual credits, favoring those with good management history and fiscal discipline in demographically favorable geographies.
U.S. CORPORATE INVESTMENT GRADE Source: Bloomberg Barclays; 9/30/2016 12%
CREDIT QUALITY
10%
On the municipal side, trends in credit metrics were relatively stable over the quarter. The general lack of voter‐approved spending can be seen in the steady
8% 6%
2% 0%
SECTOR FOCUS During this year we have steadily favored higher quality in credit sectors and positive convexity against callability in government related sectors and we do not expect that to change in the near term. While we concede that demand remains strong for all U.S. fixed income based on negative sovereign rates in multiple jurisdictions as well as central bank purchases of credit products by both the Japanese and European central banks, we feel compelled to base our investment decisions on fundamental value. Depending on strategy, we are underweight corporate bonds and over‐target U.S. government related bonds, and still maintain a relatively high level of taxable municipal exposure. In addition, we remain over‐target regarding overall quality in every credit sector with a historically low exposure to ‘BBB’ rated bonds. While this has hindered performance during 2016, we believe that it positioned us strongly to take advantage of widening, especially in corporate bonds where increased volatility is likely to widen spreads materially.
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10.79%
4% 8.01%
While there were no major shifts in credit quality over the quarter, there were pockets of strength and weakness across corporate and municipal credits, which encompass the vast majority of our credit‐ related holdings. On the corporate side of the world, most balance sheet changes are consistent with a slow growth environment where revenue growth is challenged, some levers on the cost side are still in play, and lower interest rates allow companies to save on leverage costs. Among industries on the plus side this quarter were technology, which we believe should be a secular overweight, and energy/basic materials, where a stabilization in commodity prices provided support. However, given our overall global growth estimates and the application of technologies to resource recovery, positive pricing tailwinds should be relatively short lived. On the negative side, bank and finance have come under renewed pressure based on the news flow out of Wells Fargo and a persistently flat yield curve. In the short term, this could put some pressure on credit across the sector. It also appears that multiple investigations are likely to ensue based on the Wells Fargo revelations, though it is unclear if other big banks engaged in these practices. Though this should cause some weakness, in the end, we would look for any opportunities as these actions just confirm the secular transfer of value to bondholders and away from stockholders in bank names.
2016 YTD Total Return
Taxable Market
6.80%
year. We believe issuers could be eager to secure financing before the election in November or a potential rate hike in December, both of which could cause market disruptions. That said, demand has remained steady with mutual funds experiencing 52 consecutive weeks of inflows as of 9/28/2016. Additionally, with the uptick in Municipal to Treasury ratios, Municipals appear relatively attractive based on historical averages.
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QUARTERLY BOND MARKET OVERVIEW
year‐end will likely have us actively assessing more option‐embedded securities in the government related market, like callable agency and agency guaranteed on‐the‐run mortgage‐backed securities. We have been light both sectors for an extended period of time. We would have to feel strongly that the yield advantage of negatively convex products was significant enough to warrant a shift, which we view as unlikely in the near term.
DURATION/STRUCTURE Duration and curve placement remain relatively neutral to our benchmarks with a longer duration bias to credit sectors and a lower duration profile in government related bonds. This allows us to take advantage of steeper credit curves in particular names we like. No change is expected in these portfolio metrics. Increased volatility down into
Disclosure: The material provided is for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities. The statements contained herein are based upon the opinions of Wasmer, Schroeder & Company, Inc. (WSC), the data available at the time of the presentation which may be subject to change depending on current market conditions. This presentation does not purport to be a complete overview of the topic stated, nor is it intended to be a complete discussion or analysis of the topic or securities discussed. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. WSC does not accept any liability for any loss or damage arising out of the use of all or any part of this presentation. This report should not be regarded by recipients as a substitute for the exercise of their own judgment and may contain numerous assumptions. Different assumptions could result in materially different outcomes. Please contact Wasmer, Schroeder & Company for more complete information, including the implications and appropriateness of the strategy or securities discussed herein for any particular portfolio or client. About the Firm: Wasmer, Schroeder & Company, Inc. (WSC) is an independent and employee‐owned investment advisor, specializing in fixed income separate account portfolio management for high net worth individuals, wealth management groups and institutions, including foundations, banks, endowments and retirement plans. WSC has $7.24 billion in total assets under management as of 6/30/16. The Firm works with clients and their advisors to provide taxable and tax exempt fixed income portfolio solutions to meet their needs. The Firm’s corporate headquarters is in Naples, Florida, where the Tax Exempt Portfolio Management Team, Research, Client Services, Operations, IT, Accounting, Compliance, Marketing, and Administration are located. Our Taxable Portfolio Management Team is located in Cleveland, Ohio. Client Relationship offices are located in Exton (Philadelphia area), Pennsylvania; New York, New York; and Portland, Oregon. 600 Fifth Avenue South, Suite 210
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