Volume 13: 3rd Quarter 2010
The Misnamed "Bond Market"
Navigating a Global Marketplace
When one thinks of the term “market,” the dominant image is a centralized physical area where multiple buyers and sellers congregate to exchange goods and services. In the financial markets, these centralized exchanges are increasingly electronic vs. physical, however, the notion of buyers and sellers congregating at pre-determined hours with an ability to see all things being offered for sale and bid for purchase is similar.
The equity market largely operates in this traditional market fashion. The bond market—the financial market for investing in debt securities—however, does not operate in this traditional sense nor does it deserve to be defined as a singular “market.” Rather, unlike the U.S. equity market with established, well-known exchanges, nearly all of the $825 billion average daily trading volume in U.S. bonds1 is executed in a decentralized, over-the-counter market. Further, bonds come in many varieties or sectors, each generally operating with a certain dependency on one another yet, under certain market stresses, often present very different risk and rewards.
The global bond market—$91 trillion in market value and twice the size of the global equity market2—is segregated into domestic and international issues (bonds issued or traded outside their domestic currency). The majority of any country's debt issued is generally dominated by domestic issues and very often outstanding debt represents multiples of each country's respective GDP. As illustrated, the U.S. dominates the global bond market representing 34% of global debt outstanding.
When the mass media reports on the U.S. “bond market,” they are generally referencing the ~$7.5 trillion of U.S. Treasury debt outstanding. The other sectors—totaling ~$27.5 trillion or 79% of all U.S. debt outstanding—are rarely mentioned and often move in different directions than the U.S. Treasury sector. The most recent divergence occurred in 2008 as investors fled all risky investments for the safety of Treasuries.
As mentioned earlier, the various sectors of the bond market carry very different risks and rewards. Generally speaking, bond investors are concerned with three primary risks:
- Interest Rate Risk—the sensitivity of the price change of a bond in relation to a change in interest rates;
- Credit Risk—the bond issuer's ability to pay both coupon and principal in full;
- Liquidity Risk—the ease at which bonds can be sold.
As investors accept more risk, the expectation is more reward potential. Historically, the largest divergence of risk/reward between the various sectors in the bond market has been between U.S. Treasuries and high yield. Excluding high yield, generally the remaining investment grade sectors historically illustrate similar performance. However, during periods of extreme market stress, even these sectors will have massive investment return differentials. For example, comparing index returns during the 2008 credit crisis, U.S. Treasuries returned +13.7% versus Corporates at -4.9% and Asset-backed securities at -12.7%. As the credit environment improved in 2009, we saw a reversal of sector performance with U.S. Treasuries returning -3.6% versus Corporates at +18.7% and Asset-backed securities at +24.7%.
Understanding the varying risk/reward relationship among the various sectors, bond investors must consider several factors relevant to each sector. While interest rate risk, credit risk and liquidity risk are evident in all sectors, other factors including supply/demand, corporate governance, and the municipality budget and planning process are factors specific to certain sectors.
As we look ahead at bond investing, we believe certain sectors are poised to do well while others will falter. Specifically, we are optimistic on the corporate and municipal sectors, while pessimistic on U.S. government bonds. Corporate balance sheets are incredibly clean, cash and equivalents are generally high, and the overall economic environment continues to gradually improve. Corporate bond yield spreads (i.e. the additional yield over a comparable maturity U.S. Treasury) remain historically wide at +209 basis points at the end of June 2010 versus as tight as +95 basis points in June 20053. Within the corporate sector, the bank and broker-dealer sub-sectors look very attractive as credit write-downs are decreasing and we expect to see an increase in corporate banking activity going forward.
The municipal sector also looks attractive, despite overall economic weakness with high unemployment and weak consumer spending. The overall credit quality of states is very high with 45 states rated “Aa3” or higher by Moodys. Additionally, states have low to moderate debt burdens (ranging between 0% and 7% of Gross State Product), have the power to address budget gaps, and place debt service at or near the top of the ‘priority of payments' schedule. Municipal bonds tied to essential purpose revenue sources (i.e. water, power, transportation) are also attractive as these revenues are generally not as closely tied to overall economic activity. Our main concern with the municipal sector going forward are states' underfunded pension obligations estimated at ~$450bn4. While many states have begun to take action by lowering the level of benefits for new hires, increasing retirement ages, and increasing employee contributions to the plans, further action must be taken sooner rather than later.
Clearly given the outlook and volatility of the various fixed income sectors, an investment in the bond market requires much more thought and detail. While we continue to see a normalization between the sectors, we expect divergences to continue in the short-term providing investors above average returns if positioned correctly.
1 Source: TheCityUK, June 2010.
2 Source: The Asset Allocation Advisor, 11/09.
3 Source: Bloomberg, Merrill Lynch
4 Source: The Pew Center
Disclaimer/Disclosure: First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), First Republic Trust Company ("FRTC") and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM is a SEC Registered Investment Advisor. This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein. All analyses and projections depicted herein are for illustration only, and are not intended to be representations of performance or expected results. The results achieved by individual clients will vary and will depend on a number of factors including prevailing dividend yields, market liquidity, interest rate levels, market volatilities, and the client's expressed return and risk parameters at the time the service is initiated and during the term. Past performance is not a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities, other investment or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. This document may not be reproduced or circulated without our written authority. The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that FRIM does not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document. Products and/or services offered by First Republic Securities Company, LLC, and First Republic Investment Management are not deposits or obligations of, or insured, guaranteed or endorsed by any bank, Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency, entity or person. The purchase of securities involves investment risks including the possible loss of principal.