S&P Steals the Stage Again

S&P Steals the Stage Again

January 20, 2012

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research, and
Kathy A. Jones, Vice President, Fixed Income Strategist, Schwab Center for Financial Research

Here we go again. Just when everything seemed to calm a bit in euro land and moving into a long weekend here in the U.S., Standard & Poor's (S&P) spoiled the party again. Late Friday, S&P had a downgrade party, lowering their ratings on nine European countries including two big ones—France and Italy. France and Austria lost their AAA ratings and they now rate Italy—the third largest bond issuer in the world after the U.S. and Japan—BBB+ with a negative outlook. None of this came as a surprise, but once again, negative news doesn't help ever-evolving euro zone troubles.

• While not a surprise, the timing is not helpful. The European situation looked to have taken a holiday break, due partly to efforts from the European Central Bank (ECB) to support European bank bonds…which in turn support the cost of financing for European sovereigns. (Yes, it's very confusing.) But several European countries have large bond auctions coming up, Greece is having major troubles negotiating a final deal agreed to tentatively last year to restructure debt and force private creditors to take losses on debt, and there's another European summit meeting scheduled at the end of the month.
• There hasn't been much of an immediate market reaction to the downgrades. S&P announced in early December that they'd be reviewing all of the euro zone sovereigns. In fact, the actions now have been less severe than some analysts expected. So much of the expectation had been well-anticipated. Still, the actions don't make it any easier to stop a negative feedback loop and declining confidence in stability of the euro zone. Downgrades from Moody's and Fitch could follow. And S&P also downgraded the European Financial Stability Facility (EFSF), which will make it more difficult, in our view, to stabilize yields for Italy as well as peripheral euro zone sovereigns.
• The circularity of the European situation is the most troubling issue for the market, in our view. There may not be any single "end" point, a shadow that continues to hang over global markets. The peripheral European countries are trapped in a spiral, largely due to their participation in a single currency. Their debt levels are high and growth is weak, but they can't devalue their currencies to spur growth and restore equilibrium. Harsh austerity efforts, in our view, make it worse, at least in the short-term. Debt is downgraded, it loses value, which affects the balance sheets of European banks. And around it goes.
• Recent ECB actions have been supportive, however, a major difference from 2011. Under Mario Draghi, the ECB has moved to a more accommodative stance by cutting interest rates and providing funds to the banking sector for at least the next three years. These moves are designed to allow banks and sovereigns to work on debt reduction with less stressful funding costs. The question is whether markets will give them the benefit of that time. It's beginning to sound like a broken record, but the next few months will be crucial as Europe works its way through the next phases of the crisis. We remain cautiously optimistic. But the risks remain elevated. For U.S. investors, the troubles remain supportive of demand for U.S. Treasuries and lower rates for longer.

Circularity of the European Situation

Source: Schwab Center for Financial Research.

• A quick note the January 24-25 Fed meeting…The Fed's Federal Open Market Committee (FOMC) meets next week, and it's widely expected that they'll publish their own forecasts for future interest rates for the first time. We expect that they'll take the opportunity to project lower rates well into 2013, something markets anticipate already. For those overly invested in cash relative to their objectives and risk tolerance, it's another reason to consider bond laddering and adding either some credit or interest rate risk to help generate income now.

Duration to the Benchmark

In different places and depending on when we've been asked, we've suggested both that investors should consider lengthening the duration of the bond holdings for income, and that those prone to re-balancing may want to shorten duration (the weighted average maturity of the bonds' cash flows in their portfolio) and take some gains on long-term government bonds given the strong gains in 2011. We'd like to be clearer. Which is it?

• It depends on where you start. Some investors may be heavy in cash and could extend duration, adding short and intermediate term bonds. Others may have seen significant price-driven gains in government bonds or funds with longer-than-average duration and may want to pare it back.
• Start with the taxable benchmark, or a bit shorter. The benchmark we refer to often is the Barclays Capital U.S. Aggregate Bond index. The duration for the index, which covers the U.S. taxable investment grade bond market, is around 5 years now. The average maturity is roughly 7 years. We consider 3.5 to 6 years average duration and 4-10 years average maturity to be a good starting point, to hit the benchmark.
• For investors heavy in cash… you might extend duration up to or just short of this range, to add yield. We believe that yields on cash investments and short-term bonds will remain lower, longer. This supports the view that investors with an over-allocation to cash investments may want increase the maturities of their investments, extending duration slightly, for income now.
• For investors with strong price-driven gains in 2011… with rates at very low levels, we wouldn't expect to see as much price appreciation in long-term (10+ year) government bonds. While we don't believe that rates will rise significantly, at least not quickly, if rates rise on the long end, the risks are higher. Investors inclined to re-balancing may want to take gains to move back toward the benchmark, or just shorter, during periods where yields fall.

Corporate Credit Views

A January 2012 strategy report from CreditSights, a third-party credit analysis that we read regularly, forecasts outperformance compared to Treasuries for both U.S. corporate investment grade and high-yield bonds. After near record performance in 2011 for "safe-sector" government debt, with yields as low as they are now, we believe there's simply less room for capital appreciation, and very little yield, now. In our view, investors should continue to maintain exposure to Treasuries for liquidity, credit quality and diversification. But we also agree with CreditSights that investment grade corporates may make sense as an addition to core holdings in this environment.

• Treasury yields fell in 2011, but corporate yields fell less quickly. As a result, spreads for investment-grade corporate bonds have widened compared to Treasuries. Investment-grade and high-yield spreads are now well over their post-recession averages. Barring a significant shock to the macroeconomic climate, we believe that some credit risk taken in corporates (along with munis) may strengthen returns in core bond portfolios.
• A low-yield environment supports higher-coupon corporate bonds. 2011 was about price appreciation driven by falling yields. In 2012, we believe that coupons will play a larger role. The price-driven trade has become an asymmetric one, in our view—in other words, the potential for gains are lower, while the risk is higher. For this reason, investment-grade corporate bonds look to be well balanced today between coupons and interest rate risk, in our view.
• High yield bonds are pricing in elevated default risks. Both Moody's and Standard & Poor's reported in recent data that defaults have trended down in 2011, but are projected to move slightly higher in 2012, to around 3%. Spreads now look to be similar to other periods when default expectations were higher.
• The bottom line: It's our view that the strong performance in government credit in 2011 won't continue, at least not to the same degree. For investors seeking income, consider short to intermediate-term corporate bonds or funds for income and return potential. For more aggressive investors, consider adding high yield debt in diversified solutions, but understand the inherent volatility that will come in exchange for potentially higher income now.

Barclays Capital Bond Sectors (OAS) and Moody's Historical Default Rate

Source: Barclays Capital and Moody's Investor Services. The high yield bond index is represented by the Barclays Capital U.S. Corporate High Yield Bond Index. The investment grade bond index is represented by the Barclays Capital US Corporate Bond Index. Monthly observations. Default rates are actual, trailing 12-month, speculative grade and issuer-weighted. Option-adjusted spread (OAS) is the additional yield over U.S. Treasury issues that is added to the underlying benchmark to account for embedded options, such as a borrower's option to prepay a loan. Traditionally, a higher OAS implies a potentially greater return.

Muni Downgrades to Continue

Both S&P and Moody's have been downgrading municipal bond issuers faster than they've been upgrading them over the past several quarters. Still, munis delivered double-digit returns in 2011. What gives? Can munis still deliver decent returns if downgrades continue? We think so.

• Both Moody's and S&P project that muni downgrades will continue to outpace upgrades, as do we. Downgrades exceeded upgrades during the second half of 2011 from both major rating agencies, reaching the highest levels since the beginning of the financial crisis in 2008. "Strains on core operating expenses and resources" that led to downgrades over the past three years, according to Moody's, are likely to continue in 2012. The main causes: "Economic stagnation, high unemployment, declining home values and lower consumer confidence." The data behind several of these factors are improving, but slowly. As the effects continue to be felt in pockets of the U.S., downgrades may continue.
• Downgrades haven't moved in step with a widespread increase in defaults. As we've written previously, the pressures on muni issuers, in particular state and local governments, has led to higher muni defaults, but still a very small portion of the muni market. According to Municipal Market Advisors (MMA), at the end of 2011, only 0.01% of the universe of 25,000+ rated munis was in default.
• We expect that supply and retail demand, along with Treasury rates, will continue to drive performance. As Treasury rates have fallen, so have yields on munis. Also, as return on cash investments remain near zero, fund flow data shows that individual investors have continued to see the appeal of tax-exempt income for slightly higher yields for their fixed income allocation that otherwise could have been under-invested. We'd be very surprised to see the double-digit price-driven returns again in 2012. But we believe that the fundamentals, and demand, for tax-exempt debt remain supportive.
• Consider high-quality revenue bonds and bonds of intermediate or slightly longer duration. As mentioned above, there's been high demand for short-term munis, driving yields down and leading to a steep yield curve for intermediate-term maturities or longer. We're not as comfortable with maturities much longer than 15 years for most individual investors. But investors looking to boost yield might look to add in the intermediate part of the curve (7-15 years) in laddered or barbelled portfolios. We believe that essential service revenue bonds, such as water and sewer issuers, and other revenue-secured debt can help add diversification to portfolios heavy in state and local GO issuers as well.

Will Your Trust Preferred Be Called?

Trust Preferred Securities (TruPS) are a type of preferred security, with some characteristics similar to stocks and some similar to bonds, often issued by financial institutions to help meet capital and lending requirements. Starting in January 2013, banks will no longer be able to count TruPS as part of their core capital requirements, one of the many rules and amendments as part of the Dodd-Frank Financial Reform Act. Investors should be aware that these rule changes have, and may continue, to open up TruPS to extraordinary calls.

• Regulatory changes make TruPS less attractive to banks as a form of financing. Since they can't be counted a part of their "tier 1" core capital, the first line of "loss-absorbing" reserves for financial institutions, banks who can may call existing TruPS and seek other forms of financing, such as traditional preferreds or bonds.
• Some TruPs may be subject to extraordinary calls. Most offering statements for bonds or preferred securities allow issuers to exercise extraordinary calls, typically at par, in the event of legal or regulatory changes. Several large banks have already called individual TruPS at par. We expect that we may see more leading up to and prior to the change in regulation in 2013.
• Investors holding TruPS trading at premiums to par may experience losses if securities are called. Almost half of the 144 TruPS that we monitor were priced above their par (callable) values. Take a look at existing preferred holdings for trust preferred securities and expect that some may be called.
• Many TruPS may already be trading at discounts or closer to par. Because the regulatory change has been known for some time, most TruPS are trading at prices anticipating the possibility of calls. Roughly half are trading at discounts to par, according to our data.
• The impact on preferred funds and ETFs will likely be mixed. Some TruPS are trading at premiums, some at discounts. Some may be called. Some may not. The impact on a diversified blend of preferred stocks and TruPS, we believe, is likely to be mixed. Also, based on our data, TruPS make up about one-third the share of the outstanding preferred market. So investors who hold a strategic allocation to preferred securities using funds may be less inclined to make any changes now.

Please visit www.schwab.com/onbonds for more fixed income perspective from the Schwab Center for Financial Research. If you have questions or concerns about the issues raised in this publication, please speak to your Schwab representative.

Important Disclosures

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Income from municipal bonds may be subject to the Alternative Minimum Tax (AMT), and capital appreciation from discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities mentioned herein may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. We believe the information obtained from third-party sources to be reliable, but neither Schwab nor its affiliates guarantee its accuracy, timeliness, or completeness.

International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

Past performance is no guarantee of future results.

Diversification strategies do not assure a profit and do not protect against losses in declining markets.

Barclays Capital U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is

Barclays Capital U.S. Corporate Bond Index covers the USD-denominated, investment grade, fixed-rate, taxable corporate and non-corporate bond markets. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody's, S&P, and Fitch. This index is part of the Barclays Capital US Aggregate Bond Index.

Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.