Fed Twists While Europe Simmers

June 22, 2012

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

The Schwab Center for Financial Research presents Bond Insights, a bi-weekly analysis of the top stories in today's bond markets. In this issue we discuss the Fed's decision to extend Operation Twist, the imminent downgrades to U.S. bank bonds, we take a look at the cost of the healthcare benefits in pension plans and the potential impact they can have on muni bond investors, and a look at some high-level questions on diversifying in non-U.S. bonds.

Fed Twists While Europe Simmers
Turmoil in Europe and a slow down in the US economy have been the big factors driving the bond markets over the past few months. As a result, starkly diverging trends have developed between the sovereign markets that are considered safe, such as the US, and the riskier markets such as Spain and Portugal. Amidst the market turmoil, the Federal Reserve has responded by extending Operation Twist (OT)—the program that swaps short-term government securities for long-term—through the end of the year. But the Fed did not signal that they are ready to pursue a new round of quantitative easing (QE) just yet, disappointing some investors. Meanwhile, Greece's election results provided a brief respite from turmoil in the global debt markets. There was a short-lived rally in the euro and European markets after Greece voted in pro-euro parties, but the rally lasted less than a day. What's next?

• Operation Twist 2.0 may have limited impact. The second round of OT will involve swapping $267 billion in shorter-term paper to long-term bonds. This is smaller than the first round of OT that targeted $400 billion in securities, so the impact may be limited. The Fed will only purchase Treasury bonds in this program, but the overall low level of long-term Treasury rates should help keep mortgage rates low. However, it is not as strong a signal to the market as quantitative easing since the Fed's balance sheet will not expand. Moreover, long-term Treasury yields are already near record lows, so the effects of this move could be limited on rates overall.
• The Fed's decision to extend Operation Twist (OT) may not have a big impact on the economy on the upside, but it can help limit the downside. The Fed has accounted for over 50% of long-term Treasury purchases under the first Operation Twist, so without the Fed in the market, other investors would need to step in. The Fed has made the argument that it is the stock of money that they hold, not the flow that matters. But we think the flow has helped hold down long-term rates as well. We would expect a flatter yield curve from the intermediate range (five years) to long-range (ten years and beyond).

Federal Reserve Maturity Distribution of Treasuries, Agencies, and Mortgage-backed Securities

Source Federal Reserve, as of June 13, 2012

• We still have Europe. Meanwhile, the European financial crisis is still simmering. While the outcome of the Greek elections could have been worse in terms of disrupting the markets, the underlying issues of too much debt and too little growth in the Euro zone remain. Spain is now on the front burner, with a banking sector hobbled by bad debt due to the property bubble and an economy that continues to deteriorate. Despite the recent 100 billion euro bank bailout, Spain's government bond yields remain near the highest levels in eighteen years.
• Europe trying to move towards fiscal union. There will be an EU summit June 28-29 where it is likely that European countries will take the first steps towards a tighter fiscal union. We would expect to see a roadmap laid out towards a pan-European banking union and eventually euro bonds. However, these changes take time and in some cases, changes to individual country constitutions and to EU treaties. It's a slow process and in the meantime, the markets may not be patient with the pace of change in Europe. Consequently, we think the euro is likely to remain weak against the US dollar and there is still a lot of risk in the peripheral European bond markets. We remain cautious on European bonds for most investors.
• Other Central banks will probably lower rates further. Between the unsettled market conditions and weak economic growth globally, we look for central banks to continue lowering rates. It would not be surprising to see the European Central Bank lower rates but we could also expect further easing from other countries like Canada as well as emerging market countries that have been hit by the slow down in exports to Europe and the rest of the major developed countries.
• Bottom line: We think interest rates are likely to remain low in the US and continue to trend lower in the global markets as long as economic growth remains soft. The Fed downgraded their expectations for US economic growth in their latest projections, Europe's outlook is fragile and central banks maintain a bias towards easing policy. These factors suggest interest rates will remain "lower for longer".

Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents

Source: Federal Reserve Board, June 20, 2012
Downgrades Coming for U.S. Banks Bonds
Negative economic data, the ongoing European debt saga, and imminent downgrades in the banking sector continue to weigh on bank and finance bonds. Banks are a levered play on the economy, so uncertainty in the markets often leads to higher volatility in financial securities. In the current environment, banks' bonds pose a greater risk than other corporate sectors, in our view. Although yield spreads have widened between financial bonds and Treasuries over the past few months, we believe the risk of a further rise in yields, which leads to falling prices, for bank bonds remains.

• The imminent downgrades from Moody's continue to weigh on the markets. On February 15, Moody's placed 17 global banks on review for downgrade, citing challenges such as fragile funding conditions, wider credit spreads, and increased regulatory burdens. Of the 17 banks, six are domiciled in the U.S., and all of the institutions are considered by Moody's to have "global capital markets operations." The downgrades will range from one notch to three notches, says Moody's, depending on the bank. At the time of Moody's review, the average rating of the 17 banks was A2, which means that the average rating could drop to the Baa-range.
• What do the downgrades mean for the financial industry? Prior to the 2008 credit crisis, the financial sector of the corporate index used to have a higher average rating. Five years ago, over 50% of the Barclays U.S. Investment Grade – Financial Institutions Index was rated "Aa" or better. Today, that number has dropped to 10%, with zero institutions holding the coveted "Aaa" rating. With the impending downgrades, these numbers are set to drop even more, with more and more banks potentially dropping into the "Baa" territory. Larger than expected downgrades could raise banks' funding costs, which are already elevated, putting increased pressure on their operating performance.
• Financial spreads above long-term averages, but there is risk to further widening. Financial institution bond spreads, or the amount of yield above a comparable Treasury, currently sit at their 1-year average (2.72%), but above their 10-year average (1.96%). However, financial spreads have been on the rise for the past few months, as European banking problems and trading losses at JP Morgan have spooked the markets. Despite the recent rise, a continued sell-off is possible. Just a quick look back to last November, when bank spreads hit 3.6%, can be a good reminder of what we might expect if headlines remain negative. Although bank bonds have historically offered higher yields than similarly-rated industrials, the disconnect has increased lately. The Barclays U.S. Investment Grade—Financial Institutions Index (of which the majority of issuers are rated "A" or better) trade with a higher yield than the "Baa"-rated all corporate sector index (or S&P BBB rated). Based on valuations, the market appears to have priced in the potential downgrades, although a more severe cut in ratings than investors are expecting could lead to higher yields.

Spreads on U.S. Corporate Bonds Widen

Source: Barclays US Corporate Bond index, monthly data as of June 1, 2012

• What is an investor to do? Take a look at what you hold. The downgrades have been well telegraphed, but we don't know the extent of the downgrades beyond the guidance offered from Moody's. Most of the U.S. financials that are currently on review are rated in the single "A" area and the downgrades could land them in "Baa" territory. Investors should pay attention to what they own, and how their portfolios may be affected by the downgrades. An "A"-rated security may soon be rated a few notches lower, which may not be appropriate for some portfolios.
• Bottom Line: Financial bonds may be riskier than their credit ratings imply, but we believe that large U.S. banks can offer value in a broad portfolio context. Although regulatory uncertainty may hinder profitability going forward, banks have generally done a good job of boosting their liquidity and strengthening their balance sheets. We believe that large, high quality U.S. banks can help increase yield in a diversified fixed income portfolio, but would caution that the sector may be prone to some weakness in the near-term.

AAA/AA-rated Securities as a Percent of the Barclays Financials Index

Barclays Database, quarterly data as of June 15, 2012
Add Healthcare to the Public Pension Puzzle
On May 30, we published an article on public pensions and the impact they might have on investors in municipal bonds, Could Public Pensions Sink Your Muni Bond Portfolio? In that article we didn't discuss the cost of retirement healthcare benefits for public employees. Aren't these a concern as well? Yes, they are. Our views, however, are similar to those on public pensions—these costs are a long-term threat to muni bond holders, if not addressed. For most issuers, they're not a current solvency issue. Here are other thoughts:

• Unfunded retirement healthcare benefits for state and local employees are on par with unfunded state pension liabilities. First, we're talking about the cost of paying benefits for public employees, not the cost of Medicaid and other programs designed to provide publicly-funded healthcare. Rising healthcare costs are a significant national challenge. Public retirement healthcare benefits are one part of that issue. Still, the liabilities are sizable. According to work from the Pew Center on the States, the cost of future promises made to state employees to cover healthcare benefits totaled $660 billion in fiscal 2010, with $33 billion set aside leaving a $627 billion in estimated future liabilities1. In comparison, total state pension plans had $3.07 trillion in long-term liabilities compared with $2.31 trillion saved, leaving and unfunded liability of $757 billion.
• The total liability is smaller, but the funded level is lower. As of 2010, only 5% of the future estimated costs were funded. However, half of the states accounted for 95% of the total liabilities. There's a wide variety in the benefits promised and liabilities to be funded. The Pew Center on the States has an interactive map and report cards for public consumption showing liabilities and funded status by state on its web site. Whether you own muni bonds in these states are not, it's an interesting resource.
• Before 2006, state and local governments had not been required to estimate, disclose or fund the estimated future costs of healthcare benefits. Accounting guidelines were changed, however, and state and local governments are now required to estimate and disclose these future liabilities and the annual contributions required to fund those liabilities and then include this information in notes to their financial statements. States, cities, counties and other municipalities phased in this reporting over time. As of 2008, most governments have complied. They aren't required to advance fund—meaning, save now and invest to pay for costs in the future—these liabilities with contributions into benefit plans now. However, since light has been shed on the liabilities, many have begun to at least make plans to fund these costs.
• It's important to understand the difference between estimated liabilities and annual contributions. Estimated liabilities are the estimated future costs, over 30-years or more, of these retirement benefits. Annual contributions are payments into a benefit fund to be invested to cover future costs. The liabilities are a long-term issue. Setting aside money to fund them is a current issue. The easiest course for most politicians, of course, is to delay. Historical practice has been to pay these costs on a pay-as-you-go basis. Many will continue that practice, but it's not a sustainable course long-term. Knowledgeable investors will watch which states make changes to fund the promises they've made. For states that don't, investors should demand higher yields, especially if there's a pattern of neglect over time.
• Is this more evidence of the growing credit divide? In other words, is it another case of growing differences in muni issuers, starting with states and trickling down? Yes, we think the differences are becoming increasingly important, both as muni issuers struggle with a weak economic recovery while balancing current budgets and confronting long-term challenges. The tone of austerity has encouraged reform as well, with more than 30 of the states putting in some form of change in pensions or benefits since 2008.Many analysts, including the Center of Budget and Policy Priorities, National Association of State Retirement Administrators, National Conference of State Legislatures and others have suggested that retiree healthcare costs do not enjoy the same level of constitutional and statutory protections as pensions. So they're open to reform. But the responses by state and plan will vary, leading to increased importance in credit analysis and differences in quality based on state, issuer and municipality.
• Bottom Line: To address this challenge, investors have a few choices. The Pew Center on the States study is one source of digestible analysis. They can watch carefully the differences by state and issuer, if they're worried about the long-term sustainability of various pension plans. More risk-conscious investors without this interest in credit analysis might choose to stick with the highest rated issuers or rely on professional management.

Should You Still Diversify Using Non-U.S. Bonds?
One of the casualties of the debt crisis over the past few years has been diversification. Historically, having an allocation to global bond markets has been a good source of diversification for investors. International bonds have often performed well when the US stock market has declined, while also providing a source of income and helping reduce volatility in an overall portfolio. However, the debt crisis, being global in nature, has led to a higher degree of correlation between bond markets. Moreover, the US dollar has rallied due to its perceived safe haven status, reducing the benefits of exposure to other currencies. Should investors abandon global diversification in the bond markets?

• Periods of high correlation between asset classes tend to come and go. The last few years have been extraordinary for the high level of correlation across asset classes globally and it may not be over yet. Economic growth rates appear to be synchronized and central banks are leaning towards easier policy across the globe. When U.S. stocks have fallen, historically, non-U.S. bonds have tended to deliver positive returns. Recently, however, the opposite has been the case, as concerns in Europe have led to a stronger dollar and weakening European bond market, even as U.S. stocks have fallen. The Barclays Global Aggregate bond index (a proxy for developed market bonds worldwide) fell 0.9% from April 2nd to its June 4th low, even as the S&P 500® Index fell 11%.

Short Term Bond Yields

Source: Bloomberg, monthly data as of June 19, 2012

• When we look at the potential benefits of diversification, we focus on the longer-term. For long-term investors with a ten-year investment term or longer, some allocation to global bonds still seems reasonable in our view. Major economies and markets don't always perform in sync, which can mean that non-US markets can provide relatively attractive yields and currencies.
• Emerging market bonds can add diversification for investors willing to take more risk. Emerging market countries represent an increasing share of the global economy and bond markets, and generally have higher yields and debt/GDP ratios that are half the level of the major developed market countries. However, these markets also tend to be more volatile and less liquid than the G-10 bond markets, so we suggest limiting exposure in an overall fixed income portfolio.
• Navigating the foreign bond markets is challenging even for seasoned investors. For those who want diversification, we continue to suggest professional management. This is one way to help manage through the minefields of the global debt crisis, while gaining exposure to debt in countries that have a combination of yield and return potential. Exchange-traded funds (ETFs) and index funds that track major indices may not offer the range of diversification that investors may be seeking. These indices tend to be dominated by a handful of larger issuers—the counties with the most debt—and therefore are often dominated by a few markets and currencies.
• Debt ratings haven't provided as much guidance as in the past. The rating agencies haven't been reliable indicators of performance in the past few years. For example, yields on U.S. and French bonds continued to decline even after each country was downgraded. The recent trend in the global bond market is characterized by the "safety trade" markets (the U.S., Germany, even Japan) on the one end, and the stressed markets of peripheral Europe (Greece, Spain, Italy), on the other. In the middle are a range of less debt laden developed and emerging markets such as Australia, Brazil and Canada. Ratings provided by the major rating agencies may not reflect these trends. Gaining access to foreign bond markets may also be difficult for smaller investors.

Composition of the Barclays Global Aggregate ex-US Index

Source: Barclays, Global Aggregate ex-US Index, as of June 15, 2012.
Market Value in $ billions

Actively managed funds may help providing diversification across countries and sectors.
It's a potentially perilous climate for the individual bond investor in the rolling seas of international fixed income investing. We continue to see the potential benefits in diversification longer-term, especially for investors who can stand some volatility. We think the best way to manage the climate may still be the use of professional managers to help find opportunities, but also manage risk. We suggest no more than 15% of the portfolio allocated to fixed income for investors seeking to add non-U.S. developed market bond exposure. For those who want to add currency diversification with higher potential volatility, consider "unhedged" funds. For help choosing funds, we suggest referring to Schwab's Mutual Fund OneSource Select List®, ETF Select List, or call a Schwab Fixed Income Specialist.

For additional help or a look at the mix of maturities and credit in your portfolio, talk with your financial consultant or a Schwab Fixed Income Specialist at 800-626-4600.

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.

1. Pew Center on the States, 2012. "The Widening Gap Update". Retrieved on June 18, 2012 from http://www.pewstates.org/research/reports/the-widening-gap-update-85899398241.

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Barclays Global Aggregate ex-US Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The Global Aggregate Bond Index ex US excludes the U.S. Aggregate component.

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Barclays U.S. Corporate (Investment Grade) Bond Index covers the USD-denominated investment grade, fixed-rate, taxable corporate bond market. 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 U.S. Aggregate. The Financial Institutions Index is a component of the Barclays U.S. Corporate (Investment Grade) Bond Index.

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