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FIRC Fixed Inocme, Rates, and Credit


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FIRC Fixed Inocme, Rates, and Credit

  1. 1. FIRC Fixed Income, Rates, and Credit January 15th, 2014
  2. 2. Think FIRC & Think Trading “Fixed Income” is too narrow of a definition for what we can invest in for “income” purposes. Income portfolios need to be looked at on a total return basis as much as any equity portfolio.
  3. 3. Benchmarks & Managers Matter How much were stocks up in 2013? • 22% if you invested in DJIA, 25% if you invested in SPY, and 35% if you invested in QQQ. Big differences based on the index you track. • If you move outside the US, the question of how much were stocks up varies even more. • What about the last 6 months? Spain’s 39% gain dwarfs the S&P 500’s 10%.
  4. 4. Where are Rates Headed? What rate? • 10-Year Treasury? Long bond? 3 Month LIBOR? High-yield bond yields? High-yield bond spreads? Spanish bonds? European corporate bonds? What time frame? • Over the next few days? Weeks? Months? Years? Timing is even more important in the income world where coupon and interest payments are an important factor in total return.
  5. 5. Where are Rates Headed? Intermediate Yields • Stable to slightly lower as the growth story fails to develop sufficient strength and a steep yield curve slowly drives short positions out of the market Credit Spreads • Tighter as there is sufficient growth to support the market, and the “chase for yield” encourages structured products in addition to CLO’s creating greater demand for credit
  6. 6. Managing Bond Market Risk Complex but Simple • Bonds have their own terminology that is confusing at first, but you will soon realize it is more about job security for fixed income professionals than anything that is truly difficult to understand • Think in basic “building blocks” of risk and you can’t go wrong. • Fixed Income portfolios can be customized to express risk views in ways that equity portfolios can’t.
  7. 7. Bond Market Risks Complex but Simple • Bonds have their own terminology, which while confusing at first, you will realize it is more about job security for fixed income professionals than anything that is truly difficult to understand. • Think in basic “building blocks” of risk and you can’t go wrong • Fixed Income portfolios can be customized to express risk views in ways that equity portfolios can’t.
  8. 8. Bond Market Risks – Rate And Duration Rate Risk • Typically Treasury or sovereign debt risk. The “risk-free” rate. • LIBOR, a benchmark for short-term rate risk, typically tracks Fed Funds and Bank Credit Spreads. • TIPS are traded on a “real yield” where investors can lock in a real rate of return above CPI. • Rates are expressed in yield, or bps (basis points), where 1 bp (basis point) is simply 0.01% in yield terms.
  9. 9. Bond Market Risks – Rate And Duration Duration Risk • Bonds with longer maturities generally have more interest rate risk. For a similar change in yield, a bond with a longer maturity will typically have a larger price move. • Callable bonds, typical of high-yield bonds and preferred bonds, cap their upside as they can be called, so they face “extension” risk where the effective maturity increases as prices decline
  10. 10. Bond Market Risks – Rate And Duration SHY and FLOT barely move, while TLT has much larger swings than IEF as the underlying portfolio has a much longer average duration
  11. 11. Bond Market Risks – Rate and Duration This simple table illustrates a lot of what you need to know about bond “math” or bond pricing 5 Year Treasury Yield Price Change 1.20% 101.45% 2.41% 1.45% 100.24% 1.20% 1.70% 99.05% 1.95% 97.87% -1.18% 2.20% 96.70% -2.34% 2.70% 94.42% -4.62% 3.70% 90.80% -8.25% 10 Year Treasury Yield Price Change 2.40% 103.10% 4.39% 2.65% 100.87% 2.17% 2.90% 98.71% 3.15% 96.59% -2.11% 3.40% 94.53% -4.18% 3.90% 90.55% -8.15% 4.90% 83.16% -15.54%
  12. 12. Bond Market Risks – Curve Risk Curve Risk • Bond yields have changed with the curve “steepening” which means that longer rates have increased faster than short term rates. • U.S. Treasury Yield Curves remain very steep. • Forward rates have priced in a lot of weakness as the “fair” rate for the 10 year bond yield in 1 year is about 3.35% or 0.45% than the current 10 year rate. • This process of “bootstrapping” understanding curve risk. is a key element of
  13. 13. Bond Market Risks – Bootstrapping How high can 10-year yields go? • This is a question on everyone’s mind as it is driving the corporate bond market, mortgages, and some days, even equities. • The 10-year expectations, rate inflation will be a expectations, function and of growth Federal Reserve Policy, and the shape of the curve. • While growth and inflation expectations change and investors have a wide array of views, Fed Policy and the Curve are easier to analyze, and very important to the bond market.
  14. 14. Bond Market Risks – Bootstrapping Start with the 2-year Bond • The two year bond has spent the past 6 months trading in a narrow range: 0.25% to 0.5%. • The Fed remains committed to keeping Fed Funds, the overnight rate low for the foreseeable future, in spite of creating negative real short term rates for longer than any other period in recent history. • It seems safe to assume under the current Fed the 2 year yield should stay stable around 0.40% where it currently is trading.
  15. 15. Bond Market Risks – Bootstrapping Next, Look at the 5-year Bond • The 2-year bond is at 0.4% and the 5 year bond is trading at 1.7%, towards the high end of its recent range, but well off the 0.65% low we saw last May • The 2’s 5’s spread is 1.30% or 130 bps. That is high. • For these rates to be “fairly priced” the 3-year treasury would have to yield 2.55% in 2 years. The 3-year treasury currently yields only 0.83%. That is a large rise in yields. So those that say not much is priced in, are wrong
  16. 16. Bond Market Risks – Curve Risk & the 10 Year yield The 2’s 10’s Spread going back to 1990
  17. 17. Bond Market Risks – Credit Risk Credit or “Spread” Risk is Similar to Yield Risk • Duration impacts change in spreads the same way duration impacts changes in rates. • There are credit spread “curves” which can be steep or flat and tend to invert if a credit runs into problems. • High-yield and EM spreads are typically more volatile than Investment Grade Spreads.
  18. 18. Bond Market Risks – Credit Risk Credit Spreads are often inversely correlated to Treasuries as in an improving economy makes Treasury yields go higher, but makes spreads improve. The recent extremely high correlation is unusual.
  19. 19. Bond Market Risks and the ETF’s Market Short Maturity Treasuries Intermediate Treasuries Long term Treasuries TIPS Investment Grade Bonds High Yield Corporate Floating Rate Notes Leveraged Loans Municipal Bonds Preferred Shares Emerging Market bonds Rate Yes Yes Yes Some Yes Yes No No Yes Yes Yes Duration Credit Low Low Medium Low High Low Medium Low High Medium Medium High None Low None Medium High Medium High High High High
  20. 20. A Deeper Look into Leveraged Loans vs High Yield High Yield Bonds Credit Risk High Yield Companies Interest Rate Yes, average maturity is Risk about 5 years LIBOR Risk Best Case Worst Case Not Directly Lower yields, improved credit spreads, with some M&A Activity for large total return Leveraged Loans Secured Debt of High Yield Companies Somewhat as LIBOR floor has turned many loans into fixed rate for forseeable future Due to LIBOR floors most loans will not see coupon increases even if LIBOR increases Current Coupon since most loans are callable at or near current prices The oversupply due to CLO Yields rise or we see a return demand comes back to of real credit risk haunt the market
  21. 21. FIRC Risk Management In Action YTD Performance based on ETF’s is 0.9% and 1.7% since October 1 launch. “Beta” selection, whether an ETF or mutual fund or closed end fund is critical opportunity to outperform this basic strategy as we mentioned earlier – not all indices or managers are created equal.
  22. 22. FIRC Risk Management In Action YTD Performance based on ETF’s is 1.2% and 2.5% since October 1 launch. This is designed to be a little more frequently traded, making it more difficult to execute via mutual funds but still something that needs to be considered as the performance disparity between top performing mutual funds and ETF’s grows.
  23. 23. Peter Tchir Contact Information TF Market Advisors, LLC 135 East 57th Street, 23rd Floor New York, NY 10022