Try Plan B after bond market shocks
news.ft.com
(I going for plan "G" myself as first "financial backup" plan...pb)
By John Dizard in New York
Published: August 14 2003 20:35 | Last Updated: August 14 2003 20:35
Now that fixed income investors have absorbed the first shock of the terrible losses in July and early August, they have to come up with a Plan B.
Plan A, of course, was that early retirements would be paid for by riding the two-decade decline in yields, and rise in bond prices, for a few more years, in between sipping Cosmopolitans by the pool.
So the market gods have all had a good laugh at our expense. Again. However, while everyone can't get rich all the time, that doesn't mean some of us can't turn on our less fortunate friends and make money at their expense, does it? Also, while most bond portfolios were bloodied, some were less bloodied than others. Which were they?
Let's take the last question first. While separating individual causes and effects in financial markets is difficult, some flows and backwashes are big enough to identify. David Goldman, of BankAmerica Securities, makes a good case that the initial rise in rates in June came as the Japanese authorities, through the Bank of Japan, slowed their purchases of US Treasuries. The yen was under less upward pressure and so they didn't need to buy as many dollars.
What really destroyed the market were the enormous hedging requirements of US mortgage agencies Fannie Mae and Freddie Mac. When mortgage rates fall, they have to buy Treasury bonds, or similar paper, to keep their portfolios' average maturity balanced. When mortgage rates rise, they need to sell Treasury bonds, or similar paper. In July and August, they had to sell - in carloads.
Since both Fannie and Freddie are Washington institutions, they had to fudge on saying what they were doing. The agencies said they hadn't been selling bonds. No, they weren't. They were selling the equivalent in the form of "swaptions", or derivative contracts, and the securities dealers who did that for them offset those swaptions by selling bonds.
Keeping fixed income assets and liabilities matched at the institutions required the sale of the equivalent of hundreds of billion of bonds, which accelerated the July-August crash.
For any fixed income product other than Treasury bonds, or their equivalent in other developed countries, there are two components to the rate: the pure interest rate and the credit risk.
The violence in July and early August was done to the interest rate component, represented most purely by the T-bond. When you strip that away , what you're left with is credit risk.
While interest rate volatility spiked, the volatility of the stocks has been relatively flat. Since credit risk is closely correlated with stock market volatility, the more credit ris ky products did well.
Junk bonds - or high yield, if you're a salesperson - are still well in the black for the year, with total returns (using the Citigroup indices) of around 17 per cent for the year to the end of July, even though they lost about -1.48 per cent in that month. Investment grade bonds are also still in the money for the year by about 3.05 per cent, even though they lost -4.4 per cent in July.
In contrast, the mortgage-backed securities and bonds issued by those government agencies did the worst and are now in the red for the year.
However, while the relative returns of the more risky bonds are still pretty good, the sell-off spooked their investor base. High-yield funds are showing huge redemptions, which has meant forced liquidation by the managers. "It's fair to say the rise in spreads [decline in prices] for high yield has been driven by the technicals," says Andrew Palmer of JP Morgan Chase's credit derivatives group. "Technicals" is the market term for short-term flows of cash and securities.
If you want to buy just the credit risk, which should continue to improve during the recovery, and separate that from rising Treasury bond rates, you can buy credit derivative indices from dealers such as JP Morgan Chase. Its high yield index, which is sold as a fund, has rallied from about 700 at the start of the year down to 450 at the mid-year low, then lost 75 of that gain during the sell-off.
The high grade index rallied from 131 at the start of the year down to 62 at the mid-year low, and is now around 70. Even with the sell-off, that's a lot better than the equity averages.
We won't have that strong a recovery in the US. There's just too much of a burden of debt on corporate and consumer America. That puts a cap on growth, just as the continued borrowing during the recent recession kept the decline relatively mild. So the Federal Reserve won't have to raise rates for a while.
That means you're being overpaid to insure Fannie Mae and Freddie Mac against rate rises. Just buy Fed Funds futures contracts through to the end of next year, along with futures to the middle of next year on Treasury bills.
The fixed income part of people's portfolios will just require more careful gaming in the future than it has in the past year.
johndizard@hotmail.com |
