February 11, 20102009 was a welcome respite from the past two years. Investors’ increased appetite for risk drove up prices of many financial assets, particularly high yield bonds and equities. High yield bonds were up 57.5% in 2009, as measured by the total return of the Bank of America Merrill Lynch U.S. High Yield Master II Index. While equities also posted a strong return last year, up 26.5% as measured by the total return of the S&P 500 Index, they meaningfully lagged the high yield bond market. We believe the factors behind this divergence in high yield bond and equity performance was likely due to cash flows and the carry trade.
Heightened demand for fixed income was evidenced by strong flows into that asset class. Year-to-date through November 2009, net new cash flows1 into high yield fixed-income mutual funds were $22 billion, with net new cash flows into all taxable bond funds totaling $285 billion. Stock mutual funds, on the other hand, saw negative net new cash flows of $4 billion during the same period. We are stunned by the difference in net flows, and believe it partially explains the outperformance of some fixed income markets relative to the equity market in 2009. Having been badly burned by the correction in 2008, investors shunned equities last year. However, as we all know, past performance is not indicative of future results. We feel that, over time, flows to equities will likely recover if economic conditions continue to improve. The key question for fixed income investors is: Where will the funds that may flow to equities come from? Year-to-date through November 2009, there were net new cash flows of negative $535 billion from money market funds, which were (and still are) earning virtually nothing. These outflows were the primary source of funds flowing into higher-yielding assets. In 2010, money market funds could once again be a source of funds. However, as interest rates rise, there may also be a shift away from Treasury and investment grade bonds, as these securities could be more vulnerable to adverse price movements in a rising interest rate environment. Investors may chose to swap these assets into short-term bonds, which have less interest rate sensitivity, or into equities, convertible bonds and high yield bonds, which are more economically correlated.
In addition to investment flows, another source of demand for fixed income securities has been the carry trade. With compelling direct investment opportunities being rare today, we believe that fixed income securities are serving as the higher yielding investment for many carry trades. Carry trades involve borrowing at low interest rates and investing the proceeds into higher yielding assets. The currency markets have employed this strategy for years but, recently, its use has broadened to include many more asset classes. For years, Japan was the preferred source of cheap funding relative to other regions, given their low and stable interest rates. Recently, however, the U.S. has replaced it as the favored funding source for this form of arbitrage.
Unlike pure arbitrage, however, which seeks to take advantage of small valuation differentials in very similar instruments and then adds leverage to realize acceptable returns, carry trades typically make money only if cheap funding persists. If interest rates rise, the trade is usually unwound, potentially causing weakness in the higher yielding asset. Real estate in 2003 is an example of a sizeable and very damaging carry trade. As we know, inexpensive funding was readily available and “investors” levered up to buy real estate assets, both physical and collateralized (e.g. MBS and CMOs). When interest rates rose, many were forced to give up their homes, putting strong downward pressure on real estate prices. A current example of a carry trade is being undertaken by large, commercial banks that are borrowing at the Fed Funds rate (0-0.25%) and investing the proceeds in longer-dated Treasuries, such as 10-year Treasury bonds (yielding 3.8% as of 12/31/09). As long as funding costs remain low, the banks can pocket the yield differential. Since the Treasury market is extremely large and very liquid, when it becomes necessary, the unwinding could be done in a relatively orderly way, but would still have a negative impact on the value of Treasury bonds.
The Fed is mindful of the carry trade in fixed income and is aware of the need to be deliberate and orderly in raising short-term interest rates. We hope that a sudden inflationary spike or exogenous event does not force the Fed to raise rates rapidly, as we believe this would have a significantly negative impact on the value of many fixed income assets. That said, there is evidence that the Fed may indeed begin raising rates. The yield curve has recently gotten quite steep, with the differential between 2-year and 10-year bond yields at an all-time high. The steepening yield curve is the result of several factors, including an improvement in expected future economic growth and a rise in inflation expectations. While expectations are subjective and changing, they are currently signaling that free money will soon no longer be needed to support the economy and that we are poised to begin a lengthy and durable recovery. While higher interest rates may have a negative impact on longer-dated, investment grade bonds, positive fundamentals could provide support for economically sensitive assets, such as equities and high yield bonds.
Thus, with the prospect of rising interest rates, we feel it is prudent to avoid Treasuries and underweight longer-dated assets, given the risks of severe price drops due to potential investor flows away from these asset classes, compounded with the possible unwinding of the carry trade. In this slowly improving economic environment, we feel it is optimal to hold a combination of intermediate-term high yield bonds and equity-sensitive convertible bonds, with some cash to give us the ammunition to buy opportunistically in the event of a correction. We will continue to closely monitor the macro environment for signals of interest rate changes, and will endeavor to adjust holdings as we believe appropriate. ________________________
1 Net new cash flow – Dollar value of new sales minus redemptions, combined with net exchanges. A positive number, or inflow, indicates new sales plus exchanges into fund > redemptions and exchanges out of funds. A negative number, or outflow, indicates redemptions plus exchanges out of funds > new sales plus exchanges into funds. (new sales – redemptions) + (exchanges in – exchanges out) ________________________
To receive Outlooks quarterly from Osterweis Capital Management please send us an email. Past performance is no guarantee of future results. This commentary contains the current opinions of the authors as of the date above which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index, which is widely regarded as the standard for measuring U.S. Stock market performance. It represents the 500 most widely held U.S publicly traded companies. The Bank of America Merrill Lynch U.S. High Yield Master II Index tracks the performance of U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market. You cannot invest directly in an index.
No part of this article may be reproduced in any form, or referred to in any other publication, without the express written permission of Osterweis Capital Management.
(c) Osterweis Capital Management
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