Bond Markets Rule?

July 6, 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

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 highlight the bond markets cautious response to the latest EU summit agreement; Q2 2012 performance between sectors of the global bond market; we address the Stockton, CA chapter 9 bankruptcy protection filing and take a closer look at Floating Rate Notes.

Bond Markets Rule?
European leaders surprised the markets with a more substantial agreement to stabilize bank and sovereign debt than expected. Risk markets rallied in response, but signals from the global bond markets were more cautious. On the day of the announcement, stock markets in Europe rallied as much as 6%, and economically sensitive commodities like crude oil rose by as much as 8%. However, the response in global bond markets appeared more cautious by comparison. Bond yields in Italy, Spain and Ireland declined by over 50 basis points the day the agreement was announced, but are still high relative to levels that prevailed at the beginning of the year and are still high enough to make reducing debt loads difficult. Moreover, German and US bond yields—considered safe haven markets—rose only modestly. Since many of the provisions included in the agreement were designed to appease bond holders, the divergence between the bond market reaction and the equity markets is notable. What is the divergence signaling?

• We believe it's wise to heed the cautious response of the bond markets. Europe's recent agreement reduces the risk of an imminent crisis in the banking sector and appears to be a step towards closer fiscal union. However, like everything in the markets, the devil is in the details. There is political risk because some of the terms of the agreement will need to be ratified by individual countries and then there is execution risk, since many of the plans have never been implemented before.

Ten Year Bond Yields

Source Bloomberg, as of June 13, 2012

• The key elements of the agreement… allow the European Stability Mechanism (ESM) to provide direct funding to Spanish banks rather than lending to the sovereign and it eases conditions for the bailout fund to buy government bonds. In addition, private bond holders will not be subordinated to ESM as was originally the case. These concessions to the bond markets should help ease the strains in the peripheral bond markets. Also, the European Central Bank (ECB) is to have supervisory responsibility for Europe's banking sector, but the agreement did not specify a deposit insurance program.
• While the agreement helps ease immediate pressures, longer-term concerns linger. The ESM will most likely need more funding to have the fire power it needs to deal with Europe's bad bank debt. Additionally, it isn't clear how the ECB will become Europe's banking supervisor since there is presently no structure in place for them to do so. Meanwhile, much of Europe is in recession with the most indebted countries experiencing very high rates of unemployment and contracting growth, making debt reduction and implementation of structural reforms even harder.
• Bottom line: We tend to favor the bond markets' less enthusiastic assessment of the EU summit agreement over the other markets' reactions. Europe's latest agreement has eased the immediate crisis, but there is a long way to go towards stabilizing the economies and bond markets longer term. Given weakness in economic growth in the developed countries and ongoing risks in Europe, it's reasonable that investors are likely to remain risk averse. For investors interested in international diversification, we continue to suggest minimizing exposure to European bond markets.

Q2 2012 Sector Performance
The theme of the second quarter can be described as "risk-off," as weak economic data and the ongoing European debt crisis weighed on the markets. As a result, investors flocked to "safer" assets, driving the 10-year Treasury yield to an all-time low in early June. Although safety was a theme for the second quarter, most fixed income indices, including riskier benchmarks, generated positive returns as investors continued to search for yield. We believe that disappointing economic data and the Fed on hold until at least 2014 will keep Treasury yields low, and we continue to favor intermediate term investment grade bonds.

• Treasury rally drives returns for the Barclays US Aggregate Bond Index. High demand for Treasuries, as investors worldwide continued to seek safe-haven assets, helped drive strong returns for the US bond market. Declining interest rates instead of coupon income were the major source of return. The result was a yield to maturity of only 1.98% on the index, with an average duration (i.e. weighted average timing of interest and principal payments, and a measure of interest rate risk) of just over 5 years. Treasury rates remained near all-time lows, so there is not much room for interest rates to drop further. We believe that income will have to be the key driver for returns going forward. Our "lower for longer" mantra has not changed, and we expect interest rates to remain at low levels through year-end.

Q2 2012 Performance

Source Barclays, as of July 3, 2012. Shown above are total returns for corresponding Barclays indices. Past performance is not indicative of future results.

• Investment grade corporate bonds generated positive returns across the board. High grade corporate bonds posted strong performance in the second quarter, as investors continued to search for yield in the current environment. The higher quality investment grade segments performed the best, with Aaa-rated bonds outperforming their lower-rated counterparts, and the utility sector, generally considered defensive, outperformed both financials and industrials. Corporate bond spreads, or the amount of yield over a comparable Treasury security, increased for the quarter. Such a trend is generally a sign of risk aversion. But it can also create opportunities in higher yielding bonds. Corporations have continued to reduce debt and boost their liquidity. We continue to favor investment grade corporate bonds with intermediate maturities in this environment, specifically the 5- to 7-year range.
• High yield returns show shift in sentiment to safer assets. Despite generating a positive return for the quarter, the high yield market underperformed both the higher quality investment grade index and the Treasury index. When investor risk aversion rises, high yield bonds tend to suffer as investors sell those securities and invest in higher quality or lower risk investments. For the quarter, the relative yield over Treasuries rose, negatively affecting the price of the Barclays US High Yield Index, which dropped by roughly 0.14%, while the income/coupon return was 1.97%, leading to a positive total return. This demonstrates the potential value of the high coupon, and showed how high yield can still generate a positive return in risk-off environments. For more aggressive investors, we do see relative value in the high yield market, as it offers a yield advantage of roughly 6.15% compared to Treasuries, but would exercise caution as multiple headwinds could push the risk premium even higher.
• Risk aversion negatively affecting the international markets. Euro zone troubles continue to dominate headlines and risk appetite. The so-called success of the Greek election was short-lived, as all eyes have turned to Spain, the most recent country asking for a bailout, and to a lesser degree, Italy. Foreign currency-denominated markets were negatively affected by the rise in the US dollar, leading to negative 0.4% return for the Barclays Aggregate ex-USD, an index comprised of government and investment grade bonds generally denominated in non-USD currencies. The Barclays Global Emerging Markets index was able to generate a positive return of 0.9%, although that index is denominated in the US dollar and the euro, not local currencies. Most emerging market currencies experienced declines for the quarter. In the current low rate environment, we think emerging markets may make sense for the aggressive portion of a portfolio, but a hedged approach may be best.

Stockton, CA and Muni Bankruptcy
Last week Stockton, California (pop. 292,000) became the largest U.S. city to file for chapter 9 bankruptcy protection. To most muni market watchers, the filing was no surprise. Markets have been tracking other issues, including limited new issue muni supply coupled with strong demand for tax-exempt yield more than headline risk related to individual credit stories. Stockton's bankruptcy is another case in the growing, but still short, list of local governments in default or distress. While we expect that local governments will continue to face pressures, we believe that bankruptcy for municipal governments will remain rare.

• Stockton's bankruptcy was widely telegraphed. Stockton's decision to file follows a dramatic housing boom and bust in this primarily agricultural city in California's Central Valley, followed by two years in a state of fiscal emergency, $90 million in cuts to balance the city's budget (which is required by California state law), and 90 days of negotiation under a state law passed last year (Assembly Bill 506) which requires that cities negotiate with creditors before been eligible to seek bankruptcy protection, according to news reports and city press releases. A federal court must still accept the city's petition.
• Municipal bankruptcies remain rare. Since 1937, when chapter 9 was added to federal bankruptcy code to allow for municipal bankruptcy, there have been just over 600 municipal bankruptcies, according to legal experts. Of that total, 43 have been from city and county issuers and, 33 of those cases were dismissed by a judge or did not reduce or discharge bonded debt, according to Bloomberg. Harrisburg, PA is one example. The court in Pennsylvania rejected the Harrisburg case after arguments that it violated state law. In 22 states, bankruptcy for local issuers is not permitted. And in 28 other states that do allow filing, there are varying requirements and limits to entering bankruptcy.
• Corporate bankruptcies are far more frequent, and different, than muni filings. Corporations can choose from two types of bankruptcy—chapter 7 and chapter 11. Chapter 7 involves liquidation. Chapter 11 is a form of rehabilitation, like hitting the “pause” button to negotiate and restructure. Chapter 9 bankruptcy is more like chapter 11 bankruptcy. Sizable municipalities are not generally able to simply fold up tent, liquidate, and disappear. There is also less precedent for how municipal bankruptcies operate, largely because they're so uncommon. That is one of the key issues that many will be watching. How successful will the city be in reducing costs, and who will be most impacted in bankruptcy—retirees, bondholders, city employees or some combination?
• Bondholder protections depend on a bankruptcy court—and the class of bonds. In the case of Stockton, city financial statements show that the city's debt includes lease revenue and pension obligation bonds that are secured and paid from general government revenues. These bonds do not have a dedicated tax source supporting them. Enterprise bonds, such as water and sewer bonds, are secured by net revenue pledges of the city's water and sewer systems, which have not been the source of the city's financial problems. “Since the pension and lease bonds are unsecured city obligations, they do not enjoy special protections in bankruptcy, subjecting them to possible debt service default and loss of principal,” argues Moody's in a report downgrading Stockton bonds following the bankruptcy filing.
• Bankruptcy is not the same thing as default. Defaults can happen without bankruptcy, and vice versa. Bonds with dedicated revenues for projects not the primary cause of a municipalities' distress have often been paid. Debt service on bonds that carry bond insurance will likely be paid by the bond insurer, with negotiations and losses covered by the insurer, not individual bondholders.

We suggest diversification, and a focus on tax-secured general obligation and/or essential service revenue bonds. While we don't expect a significant increase in municipal bankruptcies, we do expect that many will continue to face strains from rising costs and the weak economic recovery. So we suggest diversification and a focus on high quality debt with the strongest possible protections. We still like general obligation bonds, with a dedicated pledge of property taxes—often called an unlimited ad valorem tax pledge in a prospectus—along with essential-service water and sewer revenues bonds from stronger, more stable systems as the core for most muni portfolios.
Are Floating Rate Notes the Cure in a Low-Rate Environment?
With the Federal Reserve holding short-term interest rates at zero and suppressing long-term rates through its bond buying programs, investors continue to search for investments with higher yields. Lately some investors have looked to floating rate notes, anticipating higher yield and less risk if rates rise. Not surprisingly, this relatively small corner of the fixed income market has become popular with retail investors for these reasons. In addition to mutual funds that offer access to floating rate notes (FRNs) there are also some new ETFs that have been launched in the past few years. An even newer development is that some major corporations are offering floating rate notes directly to small investors including employees of the corporation and positioning them as alternatives to money market funds.¹

• At first glance…floating rate notes appear to offer an attractive alternative to fixed-rate bonds and notes. FRNs typically pay interest based on an index—such as the London Interbank Offer Rate (LIBOR). The notes usually have a “floor”—an initial rate for a specified period of time—often a few years—and then the rate adjusts or “floats” with the index. So if interest rates rise over time, the coupon payment will rise with the index. Sounds great, so what's the catch?
• Credit risk—no cash substitute. Based on the Barclays FRN index, most floating rate notes are investment grade but not without credit risk. (We are not including leveraged loans in this discussion. Some mutual funds combine FRNs with bank loan, leveraged loans and convertible bonds.) About 65% of the issuers are financial companies and about 26% are issued by international firms. So, it is possible that a FRN fund or ETF would have exposure to international banks—a sector of the market that has seen many credit downgrades over the past two years.
  For mutual fund or ETF investors, we suggest looking carefully at the holdings to make sure the credit quality is consistent with the investor's risk tolerance. They should not be viewed as alternatives to cash investments or CDs. Deposit insurance doesn't cover FRNs; they are subject to credit and interest rate risk, so they are not appropriate cash substitutes.

Breakdown of The Barclays U.S. Dollar Floating Rate Note (FRN) Index

Source Barclays, as of July 3, 2012

• Duration risk—may not be what you're expecting. The duration for most FRNs is short, but some are issued with long maturities or are even issued as perpetual preferred securities. If long-term interest rates rise faster than short-term rates, then the value of the note could decline due to its long duration, even if the coupon rate moves up. Moreover, once the note's floor expires, the coupon rate might actually fall if short-term rates don't move up rapidly.For example, consider a perpetual preferred FRN issued in 2011, indexed to LIBOR with a three-year 4% floor that expires in 2014. At the beginning of 2015, the coupon will float at 25 basis points over LIBOR. If the Fed begins to raise rates in early 2015, the coupon payment might actually drop if the Fed's rate hikes don't reach the 4% floor rate. Meanwhile, if long-term rates rise in anticipation of a shift in Fed policy, which is usually the case, then the FRN would most likely trade lower due to its long duration. It could be the worst of both worlds. This may not be the case for most FRNs, but we advise being careful about the maturity of FRNs and as well as duration risk in floating rate note funds.
• Liquidity—can be thin. The market for floating rate notes is small relative to the size of the overall bond market and there may not be ample liquidity, particularly in times of financial stress. For investors who are investing in fixed income for safety and liquidity, this may not be an appropriate area for investment.
• Bottom line. FRNs can provide current income in excess of what's available in cash investments without significant duration risk. However, FRNs and FRN funds and ETFs are not cash substitutes. Investors are exposed to credit, liquidity and interest rate risk. We suggest looking carefully at the investment vehicle that offers FRNs and limiting allocation to a small slice of the overall fixed income portfolio.

1. http://www.businessweek.com/printer/articles/91416?type=bloomberg

Important Disclosures

For funds, investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.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.Lower-rated securities are subject to greater credit risk, default risk and liquidity risk.International investments are subject to additional risks such as currency fluctuation, foreign taxes and regulations, differences in financial accounting standards, political instability and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.Income from tax-free 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.Past performance is no guarantee of future results.Diversification strategies do not assure a profit and do not protect against losses in declining markets.Examples provided are for illustrative purposes only and not intended to be reflective of results you should expect to attain.The Barclays Global Aggregate 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. Barclays Global Emerging Markets Index consists of the USD-denominated fixed- and floating-rate U.S. Emerging Markets Index and the fixed-rate Pan-European Emerging Markets Index, which is primarily made up of GBP- and EUR-denominated securities. The index includes emerging markets debt from the following regions: Americas, Europe, Asia, Middle East, and Africa. An emerging market is defined as any country that has a long-term foreign currency debt sovereign rating of Baa1/BBB+/BBB+ or below using the middle rating of Moody's, S&P, and Fitch.Barclays Municipal Bond Index consists of a broad selection of investment- grade general obligation and revenue bonds of maturities ranging from one year to 30 years. It is an unmanaged index representative of the tax- exempt bond market.Barclays U.S. Aggregate Bond 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.Barclays 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.Barclays U.S. Corporate High-Yield Index the 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 Ba1/BB+/BB+ or below.Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury excluding Treasury Bills and U.S. Treasury TIPS. The index rolls up to the U.S. Aggregate. Securities have USD250 million minimum par amount outstanding and at least one year until final maturity. Subindices based on maturity are inclusive of lower bounds. Intermediate maturity bands include bonds with maturities of 1 to 9.9999 years. Long maturity bands include maturities 10 years and greater.Barclays U.S. Treasury Inflation-Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).Barclays U.S. Dollar Floating Rate Note (FRN) Index measures the performance of U.S. dollar-denominated, investment-grade floating-rate notes across corporate and government-related sectors. This index is not part of the US Aggregate Index, which is a fixed coupon index. Government-related sectors include sovereigns such as Mexico and Chile.London Interbank Offer Rate (LIBOR) is a widely used benchmark for short-term interest rates. It is an interest rate at which banks borrow funds from other banks in the London interbank market; the LIBOR is fixed on a daily basis by the British Bankers' Association and derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and a full year.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.