Fixed income markets—whose stability has historically offered a refuge for investors—have been making and even breaking news in 2019. Below, our Matt Freund, CFA, Co-CIO, Head of Fixed Income Strategies and Senior Co-Portfolio Manager, weighs in on a range of topics including the inverted yield curve, negative rates and issues ahead for investors in government and corporate securities.
Freund elaborates on three common mistakes being made by investors today:
In 5,000 years of financial history, negative interest rates have not appeared until now. Today, according to Freund, one-third of the developed bond market has a negative yield to it. And those negative rates are creating problems across the capital markets.
Negative rates occur when the price of the securities is so high that even after adjusting for every expected coupon payment and the return of principal at maturity, the return would be negative.
They pose a problem because interest rates are used to price other risk instruments, Freund says.
“Think about options. Think about stocks. In theory, if rates are going to be negative forever, stocks should be much, much higher. The models will tell you they're infinite. And we know that's not true or realistic.” European financial stocks are trading today at about the same price they were 30 years ago, he adds, as an example of the challenge ahead for financial planning.
Freund is generally complimentary about the Federal Reserve, which he describes as in a “tug of war between industries that need help [lower interest rates] and industries that don't, between geographic regions that are seeing tightening financial conditions, and regions that don't.”
In the Fed’s opinion, the U.S. economy could handle higher rates, says Freund. But, because the Fed realizes “that the one rate that works for the United States is problematic for the rest of the world,” the Fed will likely continue to cut.
When the yield curve flattens or inverts—in other words, when short rates are higher than long rates—that’s a sign of pressure building in the economy, Freund says.
Here’s why: “The yield curve is a rough approximation for the cost of capital and the return on that capital for businesses. If the yield curve is flat or inverted, it shows that your return on the capital is very close to the cost. In that sort of environment there's not a lot of need to expand.”
Without a profit motive, both providers of capital and users of capital “have an incentive to slow down, to be less dynamic, and when that occurs, the economies tend to stutter.” While often considered a signal of imminent recession, Freund says that may not be the case with the inverting yield curve this year.
The U.S. government federal budget deficit crossed $1 trillion in September, many states are operating at a deficit, and low interest rates have encouraged corporate borrowing, as well.
In this video, Freund comments on three options for reducing debt: default, repayment and—what’s available to a sovereign nation—repayment in depreciated dollars.
Companies’ and states’ long-term approaches to debt reduction will involve “selective defaults, restructurings, and some pretty significant problems long-term,” according to Freund.
While there’s a chance that the federal government will tighten its belt, “I think the lure of creating inflation to solve past politicians' promises is going to prove very hard to resist,” he says.
Modern Monetary Theory (MMT)—a central bank’s creation of reserves to fund government social programs—may be unavoidable in the U.S., says Freund. “There's a host of initiatives, whether it's the Green New Deal, whether it's healthcare for all, whether it's underfunded pensions that are in desperate need of a new funding source.”
A fine theory, MMT in practice has led to trouble where it’s been tried, he explains. “Taxes are never raised high enough to offset the inflationary impulse. The government is not as efficient in allocating capital as the private sector, and the inefficiencies in capital allocation, the lack of raising taxes, causes a crisis in confidence, and once that happens things unwind very quickly,” says Freund.
There’s no such thing as “the bond market,” explains Freund. Bonds will vary based on their different characteristics—quality, duration, income, inflation “protection,” prepayment terms, etc.
“When you think about the bond market, realize that it really is a market of bonds that will behave differently and where there will be active opportunities depends upon where you are in an economic cycle,” says Freund.
Freund explains the hybrid nature of high yield bonds—whose returns generally fall in between the returns of equities and high-quality bonds. At any given time, either stocks or bonds will perform better, prompting him to comment, “When you think about high yield, it's perpetually out of favor.”
But, Freund says, investors are “being well paid for taking [high yield] risk today. And we expect that, going forward, you're going to get more income than is available in the equity markets, but with less participation on the upside. And you will get even more income than Treasuries with less interest rate sensitivity.”
Preferred securities are a third segment of the hybrid bond market, with high yield and convertible securities the other two, possibly better known segments.
Freund explains that preferreds are generally issued by companies that need help supporting the senior parts of their capital structure. “When companies have rating pressures, when the regulators or rating agencies come to them and say they need more capital to maintain investment grade ratings, they might hit the preferred market,” he says.
For the last 10 years, financials—including banks, REITs, insurance companies and master limited partnerships (MLPs)—have dominated preferred securities, according to Freund.
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Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
Fixed income securities entail interest rate risk. High yield securities are also subject to increased credit risk and liquidity risk.