Fixed Income Quarterly Report

by | Jul 7, 2021 | Uncategorized

Investor Uncertainty Remains Newsworthy

The financial markets appear sensitive as investor uncertainty continues to propagate. Inflation may be the noisiest of the fears. Perhaps the most shared uncertainty is how to reach our retirement objectives. As investors we tend to swing with general sentiments losing patience for the long-term disciplines more likely to produce favored long-term outcomes. This quarterly report touches on a few focussed long-term planning disciplines.

Be careful not to fall into the media trap. Many media outlets seem to want to sell tickets to their show. The more controversial the story, the better they can do that. It has become increasingly difficult to separate facts and logic from hype and slanted opinion. A back-to-the-basics plan may help us as investors to detach from the noise and attach to the fundamentals more likely to get us to our retirement.

Now more than ever, it seems appropriate to ask questions. It is so tempting to jump onto the latest favored investment without regard to the associated risks. We would be remiss not to emphasize the importance of maintaining wealth after you’ve earned it. Individual bonds continue to be one of the best resources to accomplish this. We ask you to take a look at the numerous resources Raymond James offers through your financial advisor to help position your assets and optimize your financial future.

 

Inflation Concerns? – Real or Hyped?

It may be difficult to admit, but people and investors alike can carry forward in a herd mentality. That is, as everyone else goes, so do I. An oil pipeline shuts down, not because of short supply or slight demand, but due to a ransomware attack. Suggestion indicates that it will be open within a week yet panic ensues pushing anxious individuals to wait in long lines filling up gas tanks and plastic containers. The pandemic threatens a kink in toilet paper supply and individuals panic, stocking months, if not years, of supply. The targeted reaction by some can result in a majority reaction… if not because of contagious thinking, then for defensive posturing.

It is not surprising that investors are concerned about inflation and over-enthusiastic about our recovery. Perhaps the real threat is inflation expectation? We have experienced how herd thinking and action moves markets and/or dictates action.

Although it is likely that inflation moves higher, we do not believe it will be high. Inflation has not been an issue for nearly 30 years so it is understandable how recent upward movement has triggered a response. A healthy moderate level of inflation is thought to drive consumption and lead to economic growth. We need to distinguish the difference between higher inflation and a sustainable over-heated economy.

Base Effect

The base effect is explained by the elevated current data relative to the past (base) comparison. Note that the last Consumer Price Index (CPI) print was

elevated (4.2) but the comparison indicates that the percent change is relative and partly explained by a low year ago (base) print (0.3). Furthermore, according to the Bureau of Labor Statistics, there was a surprise 9.6% rise in used vehicle prices.

Surprise numbers are not often sustainable (we can’t expect used car prices to rise 9.6% every month going forward). Also note that May and June of 2020 reflect low numbers and therefore we can expect at least a couple more months of elevated CPI prints.

Supply Chain Disruption

In some way, we all have likely felt the feeling of inflation. It might be via tuitions, hospital expenses, lumber costs or grocery bills. Our bias is aptly formed by our personal experiences. If you are building a house and paying for a relative’s hospital stay, inflation is very real. Yet if your children are grown and you own your house outright, inflation may not feel as extreme. Some sectors are more largely represented in inflation data than others.

The supply chain disruption was caused by the massive economic shutdowns. For example, lumber is not in short supply, but the shutdown of saw mills clogged the production. Lack of truck drivers and shipping containers prevents products from getting to consumers. Many of these issues are considered transitory and as the supply chain unclogs, it should return to normal.

Pent-up Demand

There are two parts to pent-up demand. Individuals are packing restaurants, buying up airline tickets and booking hotels. In the end, this is just going back to standard operation. If only five of your town’s eight restaurants are open, it is probable that they command elevated (transitory) prices because they can. Once competition levels, so will prices.

The other part supposes that individuals with built-up cash will spend it. Although government helicopter money (government checks sent to individuals) may be spent, the massive amount of wealth (US net worth) is disproportionately held by those 60 years of age or older. It is probable this wealth remains or transitions to investment, not consumption.

As long as the massive amounts of cash that the central banks unleashed remain in the banking system and investments, sustainable high inflation may not surface as many in the herd are predicting.

Bond Demand is Strong & Inflows are Up

Basic economics dictates that high product demand translates to higher prices. Over the past 12 months, there has been enormous demand for bonds as investors seek relative safety and reliability. The chart below puts the past year’s bond purchasing in perspective as it shows annual net fund flows into fixed income funds since 2013, versus the past 12 months.

Funds that focus on municipal bonds have experienced ~$120 billion of net inflows since this time last year. That’s $120 billion in municipal bonds that fund managers have had to go out into the market and purchase. Looking at the annual totals provides some context as to how large this number is. The average net inflows for years

2013-2020 were just over $28 billion per year. That puts the last 12 months at over 4 times the annual average. The highest annual total was in 2019, with just over $100 billion in net inflows. The past 12 months represent a >16% increase above the 2019 total. There is a large amount of money chasing a limited supply of bonds. This is a major contributing factor driving municipal prices up (yields down) over the past year.

Taxable bond funds have experienced similarly huge levels of net inflows. The

$787 billion in net inflows is almost double the highest annual total since 2013 and is nearly 4.5 times the annual average. While there are no simple and direct cause-and-effect relationships when it comes to the investment landscape, the sheer amount of money flowing into fixed income over the past year helps to explain current interest rate and spread levels.

Bonds purchased individually, through managers or through packaged products all face the same market prices, availability and interest rate environment. The money pouring into fixed income funds has managers building those funds subject to same pricing and yield levels as individuals making direct purchases of individual bonds. The primary difference being that when purchased via a packaged product, you lose the “fixed” aspects of fixed income: fixed cash flow, fixed yield, fixed redemption date, fixed redemption price.

Corporate and municipal bond yields have dropped with general interest rate shifts. Corporate spread levels are near all-time lows (see graph below). Municipal bond yields are higher than the lows experienced for much of the second half of 2020, but remain low relative to historical levels.

Allocation, Allocation, Allocation

The three most important rules of real estate: location, location, location. The three most important rules of an investment portfolio: allocation, allocation, allocation.

Growth assets are an essential element in building our wealth but holding onto that wealth is equally important. Portfolio construction relies on both growth assets and wealth preservation assets to generate a healthy financial standing and the composition of the portfolio influences this essential balance.

Imagine a portfolio that is split with 70% in growth assets and 30% in wealth preservation assets. This ratio can vary greatly depending on your accumulated wealth, risk tolerance and ability to generate income moving forward. For the purpose of demonstration, let’s use a 70%/30% split.

Growth assets are primarily total return assets or those that rely on price appreciation to deliver value. Individual bonds are favored wealth preservation assets because their features, including a stated maturity, provide a degree of assurance that is not readily duplicated or substituted with many other products. Maturities provide dates where barring default, face value is returned to the investor while during the holding period, cash flow and income are locked in.

Using investment substitutes can
disrupt the important balance
between growth and wealth preservation. For

example, high yield bonds (junk bonds) and their associated volatility can behave more in line with equities than defensive buy-and-hold individual bonds. Owning high yield bonds or other substitutes (like dividend-paying stocks) may be suitable for many investors. That’s not the point. The point is understanding that many individual bond substitutes can be slotted into the “total return” slice of your portfolio, not the wealth preservation slice.

Using 5% of the portfolio’s wealth preservation (individual bonds) and buying “substitutes” can change the desired 70%/30% split to 75%/25%. In the chart below, it is not necessarily erroneous to add 5% into high yield bonds, just note that this substitute changes the ratio of growth to preservation. The word “income” in an investment does not necessarily define its characteristics or how it interacts within the portfolio.

As the stock market oscillates (retraces and then moves higher), it serves as a reminder that large pullbacks can impact our wealth in a long-lasting manner. Make sure the balance that is appropriate for your porfolio stays intact.

Unrealized Profit/Loss

Why do you buy fixed income? For most investors, it is intended to be a portfolio ballast. Bonds exhibit stability and known attributes: a known maturity date, a known maturity value, a known yield, and known cash flows over the life of the bond. These key characteristics are locked in from the date of purchase. A lot of things can change over the holding period of the bond, but as long as the investor holds the bond until the maturity date (and barring default), any market activity (price and yield changes) are just background noise that have no effect on these key attributes.

Bond prices change over the course of time with the consequence of fluctuating gains and/or losses on financial statements. The most important thing to keep in mind is that these gains or losses are unrealized and remain so as long as the bond is held to maturity. Default or selling the bond are the only two events that can change this. The key benefits of bonds do not adjust due to shifting market prices.

Suppose a $500,000 house experiences a market price adjustment to $600,000. Does this change anything about the benefits of the home? No. The house didn’t gain an extra bedroom and change location. It still has the same number of rooms, the same square footage, and is located in the same neighborhood. It is still serving the same purpose of

providing shelter.

The same holds true if the estimated price moves in the opposite direction to $400,000. The house does not lose a room and shift location, yet it continues to provide shelter.

By comparison, market pricing changes do not alter bond characteristics and benefits. A bond’s market price can move higher or lower and it has no effect on its cash flow, income or maturity date. Statement gains or losses have no effect on bonds held to maturity and trigger consequences only if/when a bond is sold prior to maturity.

The following example illustrates this point. During the seven year holding period of this Treasury bond, the last two columns reflect market price changes and fluctuations in the unrealized gain/loss column; however, note that the cash flow, income and maturity date do not change. Also note that despite the oscillations between gains and losses over the holding period, the gain/loss column ends at $0 on the day the bond matures.

These qualities are the rationale behind fixed income allocations. Despite many unknowns and fluctuations affecting many portfolio assets, bonds provide stability and therefore more of a quality not easily attained in other asset classes.

 Your Personal Lens

Perspective goes a long way. The same product can hold very different levels of value for two people in different situations. Consider a $200 Chicago health club membership. For a resident of Chicago, that might represent a tremendous value, but for a resident of Atlanta that visits Chicago every other month, it likely has much less value.

Depending on someone’s personal tax-bracket, the exact same investment can represent a great value for one investor and a lesser value for another investor. An investor with a high tax bracket may receive greater benefits from a tax-exempt product. Just like the Atlanta resident, would likely benefit more from
joining a health club in Atlanta, investors in lower tax brackets might receive a much better value by looking at taxable products. Tax-exempt benefits provide less value to investors in lower tax brackets. Purchases viewed through your own personal lens reflect your own unique and individual situation and likely reflect the best decision for your portfolio.

The following graphs depict the same yield curves through two different investor lenses. Both show the A-rated corporate curve, the A-rated taxable municipal curve, and the A-rated tax-exempt curve. The tax-exempt curves reflect taxable-equivalent yields. The first is

shown through the lens of an investor in the top federal tax bracket of 40.8% (37% + 3.8% Medicare surtax). The second is shown through the lens of a lower tax- bracket (22% federal tax bracket) investor. Differences in relative value (how the position of the light-blue dashed line moves between the graphs) are distinct. The higher tax bracket investor can likely

Find good value across all three product types while the lower tax bracket investor’s lens shows them that tax-exempt municipals might not be the most beneficial choice from a yield perspective.

There are two takeaways that jump out. The first is that even for a top tax bracket investor, taxable products (corporates or taxable municipals) currently present viable opportunities for value. Tax-exempt

municipal bonds are trading at historically low yields leveling after-tax benefits between them and taxable alternatives.

The second takeaway is that every investor’s situation is unique. Investor differences may go beyond tax brackets (goals, liquidity needs, future spending needs, risk tolerances, etc). An ideal investment for one investor might be less-than-ideal for another. Your personal lens is the eye to optimizing investments for you!

Considering Premium Bonds

Premium bond averse investors may be missing out on numerous advantages that these bonds can provide. It is reasonable to hesitate paying $1,000,000 for only $800,000 of face value. However, what can be overlooked are the larger coupon payments that are attached to premium bonds. Premium dollars are not lost, they are returned in the form of these higher coupon payments.

Additionally, premium bonds provide advantages in a rising rate environment. Higher coupons produce additional cash flows which can be reinvested back into the higher yielding market. The greater cash flows represent income plus return of principal which has the effect of lowering the duration of the bond. A lower duration means less price sensitivity as interest rates rise.

Below is an example of two offerings, both from the same issuer, with the same maturity and roughly the same yield-to-worst. The difference is that one has a 4.45% coupon with a price of ~113 and the other has a 1.125% coupon with a price of ~99. If investing the same amount of money in each bond, the par amounts purchased will differ due to the price differences. This means that the maturity value of the high coupon bond will be $99,000, while the low coupon bond will return $113,000 at maturity.

Just as the maturity values vary quite a bit, so does the cash flow produced by each bond. This is why, at the end of the day, both of these bonds provide essentially the same return (yield) to the investor.

The premium bond provides semi-annual payments of $2,202.50 and the discount bond $635.63. There are 10 payments, therefore the premium bond

receives $22,027 and the discount bond $6,356 during the holding period.

The premium bond cost $1,268 more ($113,757 vs $112,489). The premium bond also returns $14,000 less at maturity. So far, the premium bond is $15,268 in the hole versus the par bond.

However, the cash flow for the premium bond over the remaining life of the bond will be greater by $15,671, which means the investor can net ~$400 more with the premium bond. In addition, the high coupons lower the bond’s duration (lower price volatility).

While there are many advantages to investing in premium bonds, the primary disadvantage comes into play if yields were to move lower. As stated above, in a rising rate environment, high coupon bonds tend to perform better. The opposite is also true: in a falling interest rate environment, a high coupon bond will generally underperform a low coupon bond. In a falling interest rate scenario, a high coupon bond investor is now getting more money back sooner to be reinvested into lower yielding bonds; whereas a low coupon bond will have less cash flow that needs to reinvested in the lower rate environment. For total return investors who foresee interest rates moving lower from here, lower coupon bonds could perform better.

There are many data points and bond characteristics to consider when weighing your fixed income options. You can choose bond characteristics that are based on your unique situation. Premium bonds can be a supportive option providing increased cash flows and defensive price characteristics for a rising rateenvironment.

Environmental, Social & Governance (ESG) At a Glance – What is It?

Social issues have come to the forefront over the last couple of years. Health care, education, race equity, environmental causes, hiring and employment standards and community involvement are among the numerous topics and social concerns capturing attention. Within the fixed income world, ESG addresses some of these matters. Below is a brief overview and we encourage you to ask for more detailed reports available through Fixed Income Solutions.

WHAT IS AN ESG BOND?

  • It is a debt instrument earmarked to address

    certain ESG criteria.

  • Initially, when green bonds hit the market

    they were related to environmental projects. A notable difference is that ESG bonds can be used for general funding.

    WHAT MAKES A BOND ESG?

  • There are numerous worldwide ESG

    organizations and verifiers that have guidelines and standards for ESG consideration. However, there is a not a universally accepted governing body.

  • Moody’s, S&P, Fitch and KBRA have various evaluation methods to assess ESG characteristics, their impact, and

transparency concerning ESG bonds. However, their ESG evaluations do not directly affect a bond’s financial status and have no calculated credit rating impact.

WHAT DOES THE LANDSCAPE OF THE ESG MARKET LOOK LIKE?

  • It’s a rapidly growing market with developing monitoring and recognition.

  • Global issuance of green bonds has averaged 60% annual growth since 2015 (Bloomberg LP).

  • 2020 new issuance was ~$800 billion and is expected to reach $1 trillion this year (Bloomberg LP).

  • According to Moody’s Investors Service, new issuance breakdown for 2020 was as follows: 58% Green (predecessor to Environmental), 23% Social and 19% Governance.

    WHAT DOES ESG MEAN FOR INVESTORS?

• When considering ESG bonds, consideration is more of a personal question than one of financial positioning.

At this point in time there is not a financial drawback or benefit when comparing ESG bonds to non ESG bonds.

Trader Insight

• Corporate: Spreads remain tight. There was a brief widening following the release of April’s CPI data, but the widening was relatively short-lived. Trader sentiment is that spreads may creep wider from here presenting good buying opportunities.

  • Reopening names have been popular (such as travel/leisure) as investors position for a return to a “normal” economy
  • There is generally a notable pickup in yield for Baa3/BBB-rated credits versus other investment-grade rated corporate bonds.

  • Benchmark yields and spreads remain range bound, but a move by either or both higher could be a buying opportunity.

Municipal: New issues have seen high levels of demand, with many deals being over-subscribed. This leads to many deals having their yields bumped (yields lowered) prior to final issuance.

  • Kicker bond structures have been popular for municipal investors concerned about potentially higher inflation and rising rates. A kicker bond is a high coupon bond with a short call and a longer maturity. If the bond is not called at its call date, the yield “kicks” higher the longer it remains outstanding. If interest rates move significantly higher, there is a greater likelihood that high coupon bonds will not get called.
  • The spread between higher and lower rated municipals continues to narrow creating a possible opening to reposition out of weaker credits.

  • Muni-Treasury ratios remain at historically low levels. With upcoming summer redemptions expected to be heavy, pressure is not expected to ease on the ratios in near-term. 

  • The short-end of the curve continues to experience high levels of demand (meaning prices are driven higher and yields lower) leaving very little yield value on short maturity municipals.
  • The outlook for the municipal sector is improving from a credit quality perspective, as several sectors have had their outlooks upgraded to positive by the major rating agencies during the past month.

Know What You Can Own

Most individual bonds provide investors with a few prominent features that are difficult to find in other product types, most notably: known cash flow for the life of the security, known income (yield) at the time of purchase, and a known date when principal will be returned. While most individual bonds provide these benefits to investors, there are many types of individual bonds, each having different features and applications within a portfolio. As an investor, sometimes it’s difficult to know which product is most appropriate for a particular situation. Below are listed attributes which may illustrate how various products might work within a portfolio.

–Identify acceptable risk factors.

– Define desired income.

– Create required cash flow.

– Identify requisite redemption period. Create needed liquidity.

-Isolate personal biases.

-Use appropriate asset mix.

– Diversify.

– Rebalance when applicable.

Fixed Income Strategy Resources

Doug Drabik – Sr. Fixed Income Strategist Drew O’Neil – Fixed Income Strategist Rob Tayloe – Fixed Income Strategist Rob Tribolet – Fixed Income Strategist

The Fixed Income Strategy Group provides market commentary, portfolio analysis and strategy to Raymond James financial advisors for the benefit of their clients and prospects. We are part of the larger 14- person Fixed Income Solutions group within the Raymond James’ Fixed Income Capital Markets Group’s 39 fixed income locations with more than 450 fixed income professionals including trading and public finance specialists nationwide. This publication does not constitute Fixed Income research, but rather it represents commentary from a trading perspective.

RaymondJames.com is a vast resource for those seeking fixed income market commentaries, strategies, education materials and index/yield data. Please visit our Bond Market Commentary and Analysis at www.raymondjames.com for popular and timely resources including:

–Weekly Bond Market Commentary
–FixedIncomeWeeklyPrimer(PDF)
–Municipal Bond Investor Weekly (PDF)
–Fixed Income Quarterly (PDF)
–Weekly Index Monitor (PDF)
–Weekly Interest Rate Monitor (PDF)
–Fixed Income Introduction to ESG Investing

INVESTMENT TYPES/EXPERTISE INCLUDE

–Treasuries/Agencies

–Brokered CDs

–Corporate bonds

–MBS/CMOs

–Tax-exempt municipals

-Taxable municipal bonds

–Preferred securities

Duration is the measure of a bond’s price sensitivity relative to interest rate fluctuations.

Diversification and strategic asset allocation do not ensure a profit or protect against a loss. Investments are subject to market risk, including possible loss of principal. The process of rebalancing may carry tax consequences.

Any opinions expressed are those of the author(s) and not necessarily those of Raymond James, and are subject to change without notice. Past performance is no assurance of future results.

U.S. Treasury securities are guaranteed by the U.S. government and, if held to maturity, generally offer a fixed rate of return and guaranteed principal value. Fixed-income securities (or “bonds”) are exposed to various risks including but not limited to credit (risk of default or principal and interest payments), market and liquidity, interest rate, reinvestment, legislative (changes to the tax code), and call risks. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Short-term bonds with maturities of three years or less will generally have lower yields than long term bonds which are more susceptible to interest rate risk. Credit risk includes the creditworthiness of the issuer or insurer, and possible prepayments of principal and interest. Bonds may receive credit ratings from a number of agencies however, Standard & Poor’s ratings range from AAA to D, with any bond with a rating BBB or higher considered to be investment grade. Individual investor’s results will vary. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.

Prior to transacting in any security, please discuss the suitability, potential returns, and associated risks of the transactions(s) with your Raymond James Financial Advisor.

The value of fixed income securities fluctuates and investors may receive more or less than their original investments if sold prior to maturity. Bonds are subject to price change and availability. Investments in debt securities involve a variety of risks, including credit risk, interest rate risk, and liquidity risk. Investments in debt securities rated below investment grade (commonly referred to as “junk bonds”) may be subject to greater levels of credit and liquidity risk than investments in investment grade securities. Investors who own fixed income securities should be aware of the relationship between interest rates and the price of those securities.

The information contained herein has been prepared from sources believed reliable but is not guaranteed by Raymond James & Associates, Inc. (RJA) and is not a complete summary or statement of all available data, nor is it to be construed as an offer to buy or sell any securities referred to herein. Securities identified herein are subject to availability and changes in price. All prices and/or yields are indications for informational purposes only. Additional information is available upon request.

While interest on municipal bonds is generally exempt from federal income tax, it may be subject to the federal alternative minimum tax, or state or local taxes. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax.

Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value.

New issues are offered by Official Statement only, which describes the security for such issue and which may be obtained in any state in which the undersigned may lawfully offer such issue.

Bloomberg Benchmark Magenta LineTM is provided by Bloomberg Professional service and is owned and distributed by Bloomberg Finance L.P. and its affiliates.

Investing involves risk and you may incur a profit or loss regardless of the strategy selected. Sustainable/Socially Responsible Investing (SRI) considers qualitative environmental, social and corporate governance, also known as ESG criteria, which may be subjective in nature. There are additional risks associated with Sustainable/Socially Responsible Investing (SRI), including limited diversification and the potential for increased volatility. There is no guarantee that SRI products or strategies will produce returns similar to traditional investments. Because SRI criteria exclude certain securities/products for non-financial reasons, utilizing an SRI investment strategy may result in investment returns that may be lower or higher than if decisions were based solely on investment considerations.